Understanding Price to Earnings Ratio

By Ken Little, About.com Guide

See More About:
• p-e calculation
• earnings
• stock prices
• evaluation
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If there is one number that people look at than more any other it is the Price to Earnings Ratio
(P/E). The P/E is one of those numbers that investors throw around with great authority as if it
told the whole story. Of course, it doesn’t tell the whole story (if it did, we wouldn’t need all the
other numbers.)

The P/E looks at the relationship between the stock price and the company’s earnings. The P/E
is the most popular metric of stock analysis, although it is far from the only one you should
consider.

You calculate the P/E by taking the share price and dividing it by the company’s EPS.

P/E = Stock Price / EPS

For example, a company with a share price of $40 and an EPS of 8 would have a P/E of 5 ($40 /
8 = 5).

What does P/E tell you? The P/E gives you an idea of what the market is willing to pay for the
company’s earnings. The higher the P/E the more the market is willing to pay for the
company’s earnings. Some investors read a high P/E as an overpriced stock and that may be
the case, however it can also indicate the market has high hopes for this stock’s future and
has bid up the price.

Conversely, a low P/E may indicate a “vote of no confidence” by the market or it could mean
this is a sleeper that the market has overlooked. Known as value stocks, many investors made
their fortunes spotting these “diamonds in the rough” before the rest of the market discovered
their true worth.

What is the “right” P/E? There is no correct answer to this question, because part of the answer
depends on your willingness to pay for earnings. The more you are willing to pay, which means
you believe the company has good long term prospects over and above its current position,
the higher the “right” P/E is for that particular stock in your decision-making process. Another
investor may not see the same value and think your “right” P/E is all wrong. The articles in this
series:

1. Earnings per Share – EPS

2. Price to Earnings Ratio – P/E
3. Projected Earning Growth – PEG
4. Price to Sales – P/S
 5. Price to Book – P/B
6. Dividend Payout Ratio
7. Dividend Yield

Book Price-Earnings Ratio - P/E Ratio

What Does Price-Earnings Ratio - P/E Ratio Mean?

A valuation ratio of a company's current share price compared to its per-share earnings.

Calculated as:

For example, if a company is currently trading at $43 a share and earnings over the last 12
months were $1.95 per share, the P/E ratio for the stock would be 22.05 ($43/$1.95).

EPS is usually from the last four quarters (trailing P/E), but sometimes it can be taken from the
estimates of earnings expected in the next four quarters (projected or forward P/E). A third
variation uses the sum of the last two actual quarters and the estimates of the next two quarters.

Also sometimes known as "price multiple" or "earnings multiple".

Watch: PE Ratio

Investopedia explains Price-Earnings Ratio - P/E Ratio

In general, a high P/E suggests that investors are expecting higher earnings growth in the future
compared to companies with a lower P/E. However, the P/E ratio doesn't tell us the whole story
by itself. It's usually more useful to compare the P/E ratios of one company to other companies in
the same industry, to the market in general or against the company's own historical P/E. It would
not be useful for investors using the P/E ratio as a basis for their investment to compare the P/E
of a technology company (high P/E) to a utility company (low P/E) as each industry has much
different growth prospects.

The P/E is sometimes referred to as the "multiple", because it shows how much investors are
willing to pay per dollar of earnings. If a company were currently trading at a multiple (P/E) of 20,
the interpretation is that an investor is willing to pay $20 for $1 of current earnings.

It is important that investors note an important problem that arises with the P/E measure, and to
avoid basing a decision on this measure alone. The denominator (earnings) is based on an
accounting measure of earnings that is susceptible to forms of manipulation, making the quality of
the P/E only as good as the quality of the underlying earnings number.
Filed Under: Accounting, Acronyms, Forex, Stocks
Related Terms
• Earnings
• Earnings Multiplier
• Earnings Per Share - EPS
• Forward Price To Earnings - Forward P/E
• Market Value
• Multiple
• Price-Earnings Relative
• Price-To-Book Ratio - P/B Ratio
• Price/Earnings to Growth - PEG Ratio
• Trailing Price-To-Earnings - Trailing P/E
• More Related Terms
•
8. Value
9. Return on Equity