What is the Price/Earnings (or P/E) ratio?
The Price to Earnings (P/E) ratio: is a ratio used to determining how much a potential stock buyer is willing to pay for for 1 share of common stock in a company.
The P/E ratio is the Price of 1 share of common stock divided by the earnings per share of the company. So if the price of 1 share of a company’s common stock is $10, and the EPS of the company is $.50, then the P/E ratio is 20. A P/E ratio is best used to compare the company that you are considering purchasing share of common stock in against other companies that do a similar thing. A group of companies that do a similar thing are call a Segment. An example of such a group of companies (a segment) could be the financial segment (financial firms such as Bank of America, JP Morgan Chase, Well Fargo, etc.) Another example would could be individual companies that sell a similar product as the company that you are interested in. Coke and Pepsi have similar products so if you were interesting in buy shares in either or, you would looks at the P/E ratios as part of the determination process (of course this would be just one thing to consider and not the determining factor). So Pepsi has a P/E ratio of 16.22 and and Coke has a P/E ratio of 12.76. Based on Coke and Pepsi, a P/E ratio of 20 would seem a bit high.
The real power of a P/E Ratio, is that it makes stocks comparable to other stocks in a quick glance! While it’s not a complete answer in itself, it is a powerful metric when combined with other health/growth metrics on a company. Personally I like to look at the P/E Ratio, Debt to Equity Ration, Sales growth rate, EPS Growth rate and the beta on a stock in my decision making process as to whether I’ll buy the stock or not.
