Can an Investor Use the P/E Ratio to Predict Stock Prices? - Investing Shortcuts

Can an Investor Use the P/E Ratio to Predict Stock Prices?

By July 13, 2016Stocks
Can an Investor Use the P/E Ratio to Predict Stock Prices?

Here’s a shortcut on how to come up with a price target for a stock just like the fundamental analysts do.

Many of us are familiar with the concept of the Price-Earnings (P/E) Ratio. It is often used to determine if a stock is ‘cheap’ or ‘expensive’ or considered a ‘growth’ or ‘value’ company. You hear it in the business news all the time. There is even a P/E Ratio for the S&P 500 Index!

The P/E Ratio is easily calculated:

Current Stock Price ÷ Earnings Per Share (EPS) = P/E Ratio

The most recent trailing twelve calendar months (4 full quarters) of earnings per share is generally used. The essence of the P/E Ratio is that it tells us how much the market is willing to pay for $1 of company earnings.

But the equation can also be rearranged to help us determine a future price target for a stock. If we bring the EPS over to the P/E side, the result is the following:

Stock Price = EPS x P/E Ratio

If I had the following two pieces of information:

  1. What will be the future earnings per share?
  2. What will the market be willing to pay for those earnings at that time?

I could use them in the equation and then predict stock price.

For example:

The shares of a very large and well-known digital device manufacturing company are currently trading at $90 and a P/E of 10. An analyst might look at the fundamentals of the company and expect the company to earn $11 per share over the next twelve months. He also believes that the current P/E of 10 is too low and that one year from now, when the market sees the earnings growth, the P/E will be raised to 12. Using the rearranged P/E Ratio equation, the analyst projects a one-year price target of:

$11 EPS x 12 P/E = $132 Target Stock Price

Now you know a shortcut to understanding how price targets are made by analysts and you can take your own estimates and determine a price target for yourself.

Elliot Katz

Author Elliot Katz

Elliot Katz has over 30 years of experience in the stock, options and futures markets. He has served as an options strategist and an institutional options broker. From 1989-1992, he was an instructor for The Options Institute of the CBOE. Throughout the 1990’s and early 2000’s, Elliot had roles in Senior Management at national wirehouses and private banks. Since 2007, he has worked as an independent advisor, trader, and educator.

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