# The Importance of a Price/Earnings Ratio

••• Jupiterimages/Photos.com/Getty Images
Share It

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.