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Price/Earnings (P/E) Ratio

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What Is Price/Earnings (P/E) Ratio?

The price/earnings (p/e) ratio is the relation between a company’s share price and the company’s earnings per share. Investors use it to determine whether a company is overvalued or undervalued.

Deeper Definition

The price/earnings ratio, also known as the P/E ratio, helps you compare the price of a company’s stock to the earnings generated by the company. By making the comparison, you can determine whether the market overvalues or undervalues a company’s stock.

The P/E ratio is what tool investors and analysts use to determine the relative value of a company’s shares. For investors and analysts to calculate the P/E value of a company, they need to divide its current stock price by the earnings per share. For instance, if a company’s share is trading at $10, and its earnings per share for the most recent 12-month period is $6, its P/E ratio is $12/$6, which equals $2. 

There are two ways to classify the P/E ratio: 

Forward Price/Earnings Ratio: This uses projected earnings instead of past earnings to calculate an estimated price-to-earnings ratio. The pitfall of using this metric is that a company’s projected future earnings may be overestimated or underestimated.

Trailing Price/Earnings Ratio: This uses past earnings over the past 12 months to calculate P/E. Most investors and analysts commonly use it because it is more objective. However, it is not entirely accurate since a company’s past performance does not necessarily predict its future performance.

Price/Earnings (P/E) Ratio Example

A gaming company’s stock is trading at $64 per share, while its earnings per share for the last 12 months are $5.3. To calculate the company’s P/E Ratio, investors would divide $64 by $5, which equals $12.8.

The P/E Ratio helps investors gauge the market value of a share compared to the company’s earnings. When P/E is high, it indicates that the stock may be overvalued. On the other hand, a low P/E suggests that the stock may currently be undervalued.

Companies operating in various sectors have different P/E Ratios. Therefore, when comparing two companies’ P/E, you should ensure they are in the same industry. For instance, the P/E of companies in agriculture is often lower than that of technology companies.

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