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What is a good P/E ratio? Don't leave me yet. Let's talk about this in terms of choosing friends first. Then we can talk choosing stocks.

You're grabbing dinner with sort of a new friend and you can't yet tell if you really want to hang out with this person. This person isn't very fun, kind of boring actually, and sometimes he or she is actually slightly rude. Why would you keep hanging out with this negative Nancy? Well, the question is what are you getting in the future? In the long-term? You think this person kind of stinks for now, but once x event happens or he or she gets comfortable with your other friends, this friend will be a great friend. You'll put a lot of stock into this person. Pay a high price. Pun very much intended.

Let's say company X had earnings or net income of $100 this year. Last year's earnings was $99 that's a measly 1.01% earnings growth rate. Ugh awful. Next year's earnings is expected to be $101 for a growth rate of 1%. Ew. But the company's market capitalization is $4,000, the price is $4,000 and this year's earnings is $100 for a price to earnings ratio or earnings multiple of 40. The average company in the U.S. has a P/E ratio of 17 so how can company X with the poor earnings growth get to a $4,000 market cap valuing it at 40 times earnings? The price of a company accounts for expected earnings for the next 6 to 10 years. Ultimately it's discounted cashflow, but that's a separate conversation. All of those futures cashflows are added up, in the last year of projections, a terminal growth rate is applied to those cashflows. We expect companies to remain in existence forever. Well, company X is expected to see a really high earnings growth rate for the next several years. Forget the 1% stuff. In a few years, everyone will be buying this product that X sells and earnings will explode. What if the market tanks and xXs P/E ratio falls to 30 if you think it should really be at 40 you may have found yourself a good stock. Remember to always weigh the company's earnings power against its price to see if it's undervalued or overvalued. See what other bargains are out there on the market. Then make your move.

What is a good price-to-earnings ratio? 

Well, let's go over what that is and how it's calculated first. 

Take a company's expected earnings for the next year. Then take the market capitalization (the market equity value of the company). Divide the market cap by the expected forward one year earnings number. That gives you the price-to-earnings ratio, or the earnings multiple. 

You'll notice it'll be quite a multiple. A low P/E ratio, for example, would be 10. So how does a company have $100 of expected earnings and a market value of $1,000? It's based on future cash flows for the next 6 to 10 years. 

If you still have questions, don't worry, we break it down even further in our 60 Seconds (or so) special series above.

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