The P/E Ratio Explained

Investors often use a variety of calculated metrics to determine whether the current price of a stock is “worth” their investment. By this, we mean that as an investor, there are some prices at which you might be more willing to buy a certain stock and other prices at which you might not believe that the stock is as valuable as the money you would spend on it. To assess the price of a stock relative to the potential profit that the stock might yield, many investors look at the stock’s Price-Earnings ratio (or P/E ratio, for short).

To start understanding the P/E ratio, investors must first understand the concept of per-share earnings. The term per-share earnings (also called Earnings Per Share or EPS) is defined as a company’s profit (usually from the last four quarters) divided by its number of available shares. For example, if a company earns $1 million in one year and has 1 million shares available for shareholders to purchase, its EPS would be $1 million / 1 million, or $1 per share. Obviously, this is a simple example but in reality, this EPS calculation can help investors to understand how much profit the company is expected to make for each share it sells, which can be very important for their understanding of the company’s recent performance. Further, by going through this calculation of breaking down the company’s profits on a per-share basis, investors can also start to get a better sense of what the price of this stock would be in a fair market.

Then, after calculating the EPS, investors can move on to calculate the company’s P/E ratio. The P/E ratio is comprised of two parts: the current price of one share of the company’s stock and the EPS. To calculate a P/E ratio, investors simply divide the current share price by the stock’s EPS. By going through these calculations, investors can see how much investors are willing to pay for a company’s stock per dollar of company earnings. So, if a company had a P/E ratio of 15, it would be understood that the investor would be willing to invest $15 to earn $1 of earnings.

Next, the question becomes, what is a “good” P/E ratio for a company to have before an investor decides to buy in? While P/E preferences for buying in can be personal to each individual investor and can be based on their beliefs about the company’s future success, it is generally accepted that higher P/E ratios suggest that investors are expecting higher earnings growth for the company in the future. Further, a lower P/E ratio might suggest that a company is undervalued. Finally, if a company’s P/E is listed as N/A, it means that the company either has no earnings or is losing money.

One major consideration that investors may want to compare when they look at a company’s P/E ratio is the amount of capital a company might have spent to earn the returns shown. For example, if two companies both earned $1 million profits in 2017, but one did so with a $2 million investment and the other did so with a $4 million investment, the company that invested less to make the same earnings would be considered more efficient. This could help investors to determine which company might be the “better” company in the long run. Thus, while the amount of capital used to generate earnings is not used to calculate the P/E ratio, it might be a useful metric for investors to look at before putting all of their faith in the company’s P/E ratio.

Ultimately, the P/E ratio is an extremely useful tool for investors when trying to decide if they price of a stock will be worth the value that they will gain from making their investment. This tool can help investors to compare stocks against each other on a level platform and to pick the stocks that they think will be best for their investment goals.