The Importance of a Price/Earnings Ratio

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The Price/Earnings (P/E ratio) is one of the most often-quoted statistics related to company stocks. The P/E ratio gives investors a quick way to see how cheap or how expensive a company's stock is based on how much the company earns. The higher the P/E ratio, the more expensive the stock is related to the amount of money the company earns.

Calculating the P/E Ratio

Calculating the P/E ratio for a company is relatively simple. Divide the current market price per share of stock by earnings per share over the past four quarters. If a company has a P/E ratio of 10, it means that the price of its stock costs 10 times more than the amount of money it earned per share of stock during the past year.

Stock Valuation Using the P/E Ratio

Cheap or expensive are relative terms when determining the price of a company's stock. You can't necessarily conclude that a company that has a stock price of $10 is cheaper than a company that has a stock price of $100. The price alone does not tell you anything. The P/E ratio offers much more information than the stock price because it tells you how much the company's stock costs based on how much the company earns for investors.

Industry Comparison

Determining whether a company is cheap or expensive based solely on its P/E ratio is not very useful. Comparing P/E ratios with similar stocks in similar industries can offer a much more useful way to value a company. For example, if stock XYZ has a P/E ratio of 10 and its competitor has a P/E ratio of 20, you might justifiably say that XYZ is cheap compared to its competitor.

Considerations

The implications of a low P/E ratio compared to other companies in the same industry is that the company is undervalued. However, this may not be the case. A company may have a low P/E ratio for a reason that is not easily apparent. For example, if investors believe a company has a poor management team, too much debt or other negative factors, they may be less willing to pay higher prices for its stock, which would lead to a low P/E ratio compared to other stocks in the same industry.

References

About the Author

Donald Harder has been writing financial-related articles since 2000 when he founded the firm Securities Research Services. He has worked as a speech writer for the U.S. Department of Justice and written white papers and studies for the U.S. Department of Housing and Urban Development. Harder holds a Master of Arts in international affairs from George Washington University.

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