Understanding Price Earnings Ratio (P/E Ratio)

Based on the textbook definition of Price Earnings Ratio (P/E Ratio), investors use this type of valuation ratio to see what the price of a stock should be compared to its earnings per share (EPS).

You can check out the simple formula below:

P/E Ratio = Stock Price/Earnings Per Share

For example, if Stock X sells for $50 per share and has an EPS of of $2, then the P/E is $25 (50/2).

However, most stock research sites already give you the calculated ratio, so don’t worry about doing the math:

Generally a higher P/E tells you that investors are paying more per dollar of earnings, so the stock is more expensive compared to one with a lower P/E.

As for our example, the P/E of $25 tells us that investors are currently paying $25 for every $1 of earnings. Some traders also refer to P/E has multiple, so Stock X has a multiple of $25.

Reading a P/E alone really doesn’t tell you much. Instead, to get the best use, most investors use this ratio combined with other fundamental analysis tools.

Some investors use P/E when comparing stocks in similar industries and groupings. A high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E. You can also compare similar companies. All things being constant, if one stock has a P/E twice that of another stock, it is looked at as a less attractive investment.

Problems to Price Earnings Ratio. Especially in today’s market, P/E is looked upon as more of a historical tool rather than predictor of future events. There are really no equal companies and predicting future earnings can be somewhat of a guessing game.

Since a major part of the equation involves using earnings per share, investors must rely on a company’s account procedure, which can easily be manipulated. One of the reasons I prefer technical analysis.

Lesson Learned. Just like any fundamental analysis, you must you truly understand the company of interest. How is business being done, and what are the future prospects? Using the P/E ratio alone can leave a lot of ambigous answers. For example, the higher the P/E the more the market is willing to pay for the company’s earnings. On the other hand, some investors might read a high P/E as an overpriced stock.

The price earnings ratio is just another tool in the toolbox to help you; however, before reaching a conclusion, you should definitely consider using a couple more tools in that box.

Its your turn. How do you use P/E?