- The P/E ratio (price-to-earnings ratio) measures a company’s stock price in relation to its earnings per share.
- A low P/E ratio can indicate that a stock is undervalued, while a high P/E ratio can indicate that a stock is overvalued.
- A company’s P/E ratio mainly provides insight when compared to others in the same industry, or its sector overall.
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When picking stocks to invest in, everyone always wants to get a good deal — companies that not only are worthwhile but are trading at a decent price. But how do you determine that decent price? It’s not necessarily a question of dollar amounts.
One time-honored tool for evaluating a stock — and the company behind it — is the price-to-earnings ratio, or P/E ratio for short.
The P/E ratio is a measure that allows investors to analyze the trading price of a stock’s shares, and to compare it to other companies’. In essence, it will tell you if the stock is trading at a sound investment level or at a speculative level.
How the P/E ratio works
Expressed as a single number, the price-to-earnings (P/E) ratio measures a company’s stock price in relation to its earnings per share (EPS).
The P/E ratio, along with earnings per share, is usually indicated on a stock’s online listings page. But if you wanted to figure it yourself:
The P/E ratio tells an investor how much hypothetically they are paying for $1 of a company’s profits. So, for example, if the share price of a company is $50 and its EPS is $5, the P/E ratio would be 10. In effect, an investor would be willing to pay $10 for $1 of a company’s earnings if they purchased the stock.
Now, if another company in the same industry also has a share price of $50 but an EPS of $20, its P/E ratio would be 2.5, meaning it would cost $2.5 to purchase $1 of that company’s earnings. The second company is the better value, in theory, if all other variables are equal.
The significance of the P/E ratio
The P/E ratio is a large component of value investing, a strategy that seeks out companies whose stocks appear to be trading below their fundamental worth.
In general, a low P/E ratio can indicate that a stock is undervalued or that it is performing well, while a high P/E ratio can indicate that a stock is overvalued or that investors expect its performance to improve in the future.
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