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What is the price/earnings ratio?
The price/earnings ratio, also called the P/E ratio, tells investors how much a company is worth. The P/E ratio simply the stock price divided by the company’s earnings per share for a designated period like the past 12 months. The price/earnings ratio conveys how much investors will pay per share for $1 of earnings.
Investors look at a company’s price/earnings ratio to determine whether to invest. They use the market value per share in relation to earnings per share to find the ratio. When the P/E ratio is calculated across a period of previous quarters, it’s called a trailing P/E, which is the most common type. When the price/earnings ratio is calculated using estimated net earnings of upcoming quarters, it’s called a future P/E.
The P/E ratio shows how much growth investors expect from companies they invest in. A high ratio indicates that investors are paying much more per share than the company is earning, which is common in new businesses with a lot of investment capital, like tech start-ups. Lower ratios indicate that growth has slowed, but that doesn’t necessarily mean the company is failing; in fact, a lower P/E ratio may mean the company has solidified its market share.
The price/earnings ratio also can be used to gauge the market as a whole if different companies from the same industry are examined over the same period. This kind of comparison can help an investor determine if a given company is over- or undervalued.
With the P/E ratio in mind, you might be ready to invest. With a high-interest savings account, you can build funds to put toward stocks.
Price/earnings ratio example
On September 30, 2015, Apple’s stock ended the day at a price of $110.30. Apple’s earnings per share for the trailing 12 months was $8.66. Divide the stock price by the EPS and — voila! — you get a price/earnings ratio of 12.74.
That same day, Morningstar, an investment research firm, says that the P/E ratio of the S&P 500 was 18. Together, this information informs investors that Apple’s stock may have been undervalued as of that date.