The P/E ratio (price-to-earnings ratio) of a stock is a measure of the
price paid for a share relative to the annual net income or profit earned
by the firm per share. It is a financial ratio used for valuation: a
higher P/E ratio means that investors are paying more for each unit of net
income, so the stock is more expensive compared to one with lower P/E
P/E ratio is caculated as:
P/E ratio= Market Price per share / Annual
earnings per share
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).
Theoretically, a stock's P/E tells us how much investors are willing to
pay per dollar of earnings. For this reason it's also called the
"multiple" of a stock. In other words, a P/E ratio of 20 suggests that
investors in the stock are willing to pay $20 for every $1 of earnings
that the company generates. However, this is a far too simplistic way of
viewing the P/E because it fails to take into account the company's growth
Growth of Earnings
Although the EPS figure in the P/E is usually based on earnings from the
last four quarters, the P/E is more than a measure of a company's past
performance. It also takes into account market expectations for a
company's growth. Remember, stock prices reflect what investors think a
company will be worth. Future growth is already accounted for in the stock
price. As a result, a better way of interpreting the P/E ratio is as a
reflection of the market's optimism concerning a company's growth
If a company has a P/E higher than the market or industry average, this
means that the market is expecting big things over the next few months or
years. A company with a high P/E ratio will eventually have to live up to
the high rating by substantially increasing its earnings, or the stock
price will need to drop.
A good example is Microsoft. Several years ago, when it was growing by
leaps and bounds, and its P/E ratio was over 100. Today, Microsoft is one
of the largest companies in the world, so its revenues and earnings can't
maintain the same growth as before. As a result, its P/E had dropped to 43
by June 2002. This reduction in the P/E ratio is a common occurrence as
high-growth startups solidify their reputations and turn into blue chips.
Cheap or Expensive?
The P/E ratio is a much better indicator of the value of a stock than the
market price alone. For example, all things being equal, a $10 stock with
a P/E of 75 is much more "expensive" than a $100 stock with a P/E of 20.
That being said, there are limits to this form of analysis - you can't
just compare the P/Es of two different companies to determine which is a
It's difficult to determine whether a particular P/E is high or low
without taking into account two main factors:
1). Company growth rates - How fast has the company been growing in the
past, and are these rates expected to increase, or at least continue, in
the future? Something isn't right if a company has only grown at 5% in the
past and still has a stratospheric P/E. If projected growth rates don't
justify the P/E, then a stock might be overpriced. In this situation, all
you have to do is calculate the P/E using projected EPS.
2). Industry - It is only useful to compare companies if they are in the
same industry. For example, utilities typically have low multiples because
they are low growth, stable industries. In contrast, the technology
industry is characterized by phenomenal growth rates and constant change.
Comparing a tech company to a utility is useless. You should only compare
high-growth companies to others in the same industry, or to the industry