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Price to Earning ratio is one of the most well-known valuation tools investors use to estimate the company’s intrinsic value. P/E ratio is calculated by dividing the company market capitalization over the year net income. The information is extracted from the company’s reported income statement.
P/E = Market Capitalization / Net Income
P/E ratio helps investors to know the stock market value compared to its earnings. It represents how much investors are willing to pay for each EGP 1 of income. A P/E ratio of 15x, means that investors are willing to pay EGP 15 to get 1 EGP of profits.
Lower P/E ratios indicate that the current share price is relatively low and probably undervalued, but can also indicate that investors are pessimistic about the company’s future or that its earnings have been shrinking over the year. Higher P/E ratios indicate that the share price is high and probably overvalued, but can also indicate that it’s a fast growing company and its profitability will significantly improve over time.
What is a good P/E ratio?
There’s no universal fair ratio. Every stock should be assessed by comparing it to similar companies in the same industry/sector. Sectors with high growth prospects, like the technology sector, tend to have higher P/E ratios, as investors are willing to pay more now for returns in the future. Mature companies in traditional sectors tend to have lower P/E ratios like the Banking industry in EGX which has an average P/E of 5.3x.
Before picking any stock, it’s highly recommended to look at the P/E ratio and compare it with similar companies in the same industry & market.