Eli5 the concept of using Market Capitalization and P/E Ratios to choose stocks to buy
In: Economics
Market Cap would only indicate a company’s size (in terms of equity value), which would mostly just serve as a rough proxy of the risk involved. Typically, smaller caps are riskier and as a result come at a lower price.
P/E is just the ratio of price to earnings. As a simplification, it’s how much the company earns relative to how much it costs to own the company.
Would just invest in ETFs if I were you though. I’ve met a few people who are genuinely equipped to “outsmart” the market, and they do so conservatively. They also come from financial market backgrounds and basically worked in the field. Contrast this with your average wannabe that basically flips a coin to figure out if they’re “smart” or “unlucky”.
Assume a shop makes $100,000 every year. The owner is offering to sell the shop to you at the price of 1 million.
In this example, the P/E ratio will be 10. Since the price you pay for the shop is 10 times it’s annual earnings.
If the P/E is high, then it might mean that people expect the profit to grow in future so are willing to pay more. Or it could also mean that the price being asked is too high and it is a bad deal.
On the other hand, if P/E is low then it might mean that you are getting a bargain. Or it might also mean that the prospects of the business look pretty bad and it’s earnings might decline.
In real life, the business will not be sold or bought as a whole, so PE is the price of 1 share in the market divided by earning per share, which is calculated as earnings divided by the number of shares.
Market capitalisation means the market value of the business. In the shop example, it is $1 million. You can think of it as the amount you will have to pay if you want to buy all the shares of the company.
In general, if a company has a low P/E ratio you would buy it because you believe that it’s mispriced and that it’ll bounce up when others recognize its true value. By contrast if the company has a high P/E ratio the stock is high priced, and you’d only buy it because you believe the company has growth potential.
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