What is a P/E Ratio?

In finance, the P/E ratio of a stock (also called its “earnings multiple”, or simply “multiple” or “PE”) is used to measure how
cheap or expensive share prices are. It is probably the single most consistent red flag to excessive optimism and over-investment. It also serves, regularly, as a marker of business problems and opportunities. By relating price and earnings per share for a company, one can analyze the market's valuation of a company's shares relative to the wealth the company is actually creating. A P/E ratio is calculated as:

P/E ratio = Price per Share/Earnings per Share

The price per share (numerator) is the market price of a single share of the stock. The earnings per share (denominator) is the net income of the company for the most recent 12 month period, divided by number of shares outstanding.

The P/E of a stock describes the price of a share relative to the earnings of the underlying asset. The lower the P/E, the less you have to pay for the stock, relative to what you can expect to earn from it. The higher the P/E the more over-valued the stock is.

For example, if stock A is trading at $24 and the Earnings per share for the most recent 12 month period is $3, then the P/E ratio is 24/3=8. Stock A said to have a P/E of 8 (or a multiple of 8). Put another way, you are paying $8 for every one dollar of earnings.

The main reason to calculate P/Es is for investors to compare the value of stocks, one stock with another. If one stock has a P/E twice that of another stock, it is probably a less attractive investment. But comparisons between industries, between countries, and between time periods are dangerous. To have faith in a comparison of P/E ratios, you should be comparing comparable stocks.

Normally, stocks with high earning growth are traded at higher P/E values. Say, Stock A may earn $6 per share the next year. Then the future P/E ratio is $24/6 = 4. i.e. you are paying $4 for every one dollar of earnings which is more attractive.

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