Determining share prices

Share prices in a public quoted company is determined by market supply and demand and thus depends upon the expectations of the buyers and sellers of many factors, amongst these:

The company's future and recent performance
New product lines
Prospects for companies of this type, the “market sector”
Prevailing moods & fashions.

By dividing the price of one share in a company by the profits earned by the company per share, the P/E ratio is arrived at. If earnings move up in line with share prices (or vice versa) the ratio stays the same.
But if stock prices gain in value and earnings remain the same or go down, the P/E rises. For example, if a stock price was $70 per share and it got $2 in earnings, the P/E is 35, historically high. The price used to calculate a P/E ratio is usually the most recent price. The earnings figure used is the most recent available but this figure is often a year old and does not necessarily reflect the current position of the company.

Various interpretation of a particular P/E ratio are possible.

0-13 - Either the stock is undervalued or the company's earnings are thought to be in decline.
14-20 - For many companies a P/E ratio in this range may be considered fair value.
1. The average U.S. equity P/E ratio is usually around 14, meaning it takes about 14 years for a company you purchase to earn back your full purchase price for you.
2. Average P/E over the entire market is a good indicator of overall market strength.
21-28 - Either the stock is overvalued or the company's earnings have increased since the last earnings figure was published.
28+ - A company whose shares have a very high P/E either really does have an exceptionally rosy future or the stock may be the subject of a speculative bubble.
A company with no earnings has an undefined P/E ratio.

P/E ratios tend to rise and fall in line with current and anticipated interest rates and investment returns available elsewhere. If the prevailing bank interest rate rises then one would expect P/E ratios to decline because some investors and speculators may choose to invest in cash rather than shares. A P/E ratio of 25 corresponds to a 4% return on investment [ROI], so if the risk-free interest rate is at or above this level there is little point in investing in a stock at a 25 P/E. Investors often choose to take a lower ROI by investing in shares in a company with some future growth potential.

Normally, the lower the (real) rates, the higher the P/Es. Stock prices are “interest rate-sensitive”.

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