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).
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.
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.
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.
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.
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