The price-to-earnings (P/E) ratio is calculated by dividing a stock's market price per share by its earnings per share. Thus, when the price of a stock rises and earnings remain constant, the P/E ratio will rise, diluting the stock's value. There are a number of factors that can cause a stock's value to increase or decrease when investors buy or sell shares in response to them.
Companies that reinvest earnings, building new factories and otherwise expanding their operations, sometimes have relatively high P/E ratios. This occurs because many investors are willing to buy the stock at higher and higher share prices in expectation of a future payoff from the company's investment. Likewise, investing in future growth does not always immediately translate into higher current earnings.
Dividends and the Ratio
Paying dividends can cause a company's P/E ratio to rise. Paying dividends does not increase earnings, yet many investors are willing to pay higher prices for stocks to receive regular dividend payments. Demand for divident-paying stock goes up when interest rates are low, since dividends can be a good alternative to low interest, and goes down when interest rates are high. Thus, it makes sense that investors would be willing to pay higher share prices to earn cash dividends.
Fear and Greed
Stock prices are not always determined as a result of rational investor behavior. Stock prices also rise and fall in response to fear and greed, whether in response to overall market conditions or prevailing investor wisdom about a particular company and its stock. When stock prices are steadily rising, investors can become greedy, buying shares at higher prices in expectation of even higher prices. When stocks are falling, investors can panic and sell their shares out of fear they will fall even further, bringing prices down. Fear and greed do not have the same impact on earnings, so P/E ratios will rise and fall with rising and falling stock prices.
When a company increases its debt, it can cause the P/E ratio for its stock to fall. Many investors concerned that the costs of higher debt will negatively impact the company's future earnings sell their shares in response, causing share prices to decline. Thus, a lower P/E ratio does not always indicate higher stock value. Sometimes P/E ratios fall in response to increased risk. This is effectively the opposite of P/E ratios rising in response to expectations of future growth. Investors believe that debt will constrain the company's growth and price the stock accordingly.