Eli5 the concept of using Market Capitalization and P/E Ratios to choose stocks to buy
In: Economics
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.
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