A stock’s price-to-earnings ratio is a comparison of a company’s price per share and annual earnings per share. It is calculated as the price per share divided by the annual earnings per share (P/E ratio = Price per share/Earnings per share). For example, if the current price per share of stock is $20 and the earnings in the previous 12 months is $1.30 per share, the P/E ratio would be 15.38 ($20/$1.30).
Even though a stock’s P/E ratio is not the only indicator of its performance, a high P/E implies that stockholders are anticipating a future of higher earnings, and vice versa. History shows that the average P/E ratio in the stock market has been 15 to 25. This figure can vary depending on the state of the economy and/or types of companies and industries. Comparing the P/E ratios of two or more companies within a particular industry is also a method of predicting growth.
Some people refer to the P/E as the “multiple” because it explains the amount stockholders are prepared to pay for every dollar of earnings. In other words, if the multiple (P/E) of a company is 10, that means a stockholder will agree to pay $10 for every $1 of earnings.
Three points to consider:
-- Companies with negative earnings do not have a P/E ratio.
-- During times of high inflation, P/E ratios are generally lower.
-- Estimated earnings can be used to approximate a future P/E ratio.
You can find out more information on how the P/E is calculated and what it is used for by visiting www.morningstar.com/InvGlossary/price_earnings_ratio.aspx.
