P/E ratio definition

What is the price-to-earnings ratio?

The price-to-earnings ratio, or P/E ratio for short, is a method of measuring a company’s value. The P/E ratio is calculated by dividing the company’s market value per share by the earnings per share (EPS).

A high P/E ratio suggests that investors expect a high level of earnings in the future, and that growth will be strong. A low P/E ratio could mean that the company is undervalued or current earnings are exceeding past trends.

Why do investors calculate the P/E ratio of a company?

Investors calculate the P/E ratio of a company so that they can compare the value of one stock in a sector with another. The price-to-earnings ratio can also be used as a guide to determine whether a company is currently over- or undervalued compared with its historical averages.

Sometimes, traders and investors will also calculate a trailing P/E ratio using an average of the past four quarters’ earnings to look at historical performance, or a forward P/E ratio using average analysts’ earnings expectations for the following four quarters.

Pros and cons of using the price-to-earnings ratio

Pros of using the P/E ratio

By measuring a company’s price to earnings, investors can determine whether shares are over- or undervalued, and decide which stocks to buy. For the company itself, the P/E ratio is a useful indicator of how much confidence investors have in the business.

Cons of using the P/E ratio

Using the P/E ratio as a measure of a company’s stock value has its limitations and should not be used as a single indicator of a company’s value. A price-to-earnings ratio doesn’t mean much until you compare it to the rest of the stocks in the same sector, or other companies listed on the same index.

Example of the P/E ratio

Let’s say you’re interested in buying shares of company ABC, which are currently trading at $100 per share. If the company currently has earnings per share of $8, this would give a P/E ratio of 12.5 ($100/$8). So, you’d have to invest $12.5 for every $1 In profit.