The Price/Earnings (P/E) Ratio: Definition and Use
The P/E ratio (price-to-earnings ratio) measures the price of a share relative to company earnings company earnings on a per share basis. A higher P/E ratio indicates a willingness by investors to pay more for a unit of income. The measure is most valuable when viewed over time for the emergence of a trend. While a company with an increasing P/E has found favor with stock investors, it may be becoming more speculative. High ratios (usually associated with growth stocks) may leave investors wondering if the stock is worth the risk or if it may be overvalued.
Calculating the P/E Ratio
To compute a company’s P/E ratio, divide the current stock price by that company’s per-share earnings (EPS). In comparing the ratios of various stocks, an investor can understand the market’s relative valuation of each. If one stock has a value that is much higher than the others, with all else being equal that stock is viewed as a less attractive investment opportunity. A company with a high P/E will eventually have to perform to the level investors are expecting through substantial increases in earnings. Otherwise, the stock price will eventually drop.
Compare to the PEG Ratio
Ratio Averages
In recent years, the price/earnings ratios of technology companies have fluctuated between 22 and 47. This industry saw dramatic increases in the late 90s due to the soaring expectations (which, as it turned out, could not be sustained). Over the same time period, companies outside of the technology sector have seen fluctuating values of between 14 and 23.
The Potential Risk of Low P/E Ratios
Low P/E ratios are often associated with value stocks. But even low P/E stocks should be approached with caution as there is often a reason they are available at such a cheap price as stocks that decline usually do so for good reason. It could be the emergence of new competitors, an upheaval in the management team or that the company has warned of lower than expected earnings.
What the Measure is Really Telling You
While the P/E ratio is a better indicator of the value of a stock than the market price alone, there are limits to what it offers investors. A simple comparison of the ratios of two companies will not, by itself, indicate which is a better value. Instead, the measure should be taken for what it really is, a reflection of the level of optimism the market has concerning any particular firm’s growth prospects.
More about the definition and use of the P/E Ratio
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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.
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