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P/E Ratio

A valuation ratio of a company's current share price compared to its per-share earnings.

Calculated as: Market Value per Share/Earnings per Share (EPS)

For example, if a company is currently trading at $43 a share and earnings over the last 12 months were $1.95 per share, the P/E ratio for the stock would be 22.05 ($43/$1.95).

EPS is usually from the last four quarters (trailing P/E), but sometimes it can be taken from the estimates of earnings expected in the next four quarters (projected or forward P/E). A third variation uses the sum of the last two actual quarters and the estimates of the next two quarters.

Also sometimes known as "price multiple" or "earnings multiple."

The best way to understand the significance of the P/E ratio is to turn it upside down. If you divide the earnings by the price (E/P) you get the inverse of the P/E ratio, which is called the earnings yield. The earnings yield tells an investor how much return (on a per-share basis) the stock's shareholders earned over the past 12 months, based on the current share price. Remember that earnings, regardless of whether they are paid out in the form of a dividend or retained by the company for reinvestment into further growth opportunities, still belongs to the shareholders. Shareholders hope that these earnings will grow going forward, but there is no way to perfectly predict what that growth will be.

In general, a high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E. However, the P/E ratio doesn't tell us the whole story by itself. It's usually more useful to compare the P/E ratios of one company to other companies in the same industry, to the market in general or against the company's own historical P/E. It would not be useful for investors using the P/E ratio as a basis for their investment to compare the P/E of a technology company (high P/E) to a utility company (low P/E) as each industry has much different growth prospects.

The P/E is sometimes referred to as the "multiple", because it shows how much investors are willing to pay per dollar of earnings. If a company were currently trading at a multiple (P/E) of 20, the interpretation is that an investor is willing to pay $20 for $1 of current earnings.

It is important that investors note an important problem that arises with the P/E measure, and to avoid basing a decision on this measure alone. The denominator (earnings) is based on an accounting measure of earning that is susceptible to forms of manipulation, making the quality of the P/E only as good as the quality of the underlying earnings number.

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