Stock investors are generally after one thing — a rising stock price. The P/E ratio of a stock doesn’t guarantee a higher price, but it can be a way to fairly compare two or more stocks.
Stocks go up in value, for the most part, because investors believe that earnings are going to rise.
Rising earnings usually means rising profits. Since investors are owners of the company via their stock holdings, they are eligible to share in those profits.
Often, investors choose from among several stocks that are similar in size and type. Two computer makers, for instance, or two car companies.
That’s why they try to look into the growth prospects of each company via the price-to-earnings ratio, or P/E ratio.
A P/E ratio is a relatively simple mathematical expression that explains how much it costs to own a company’s earnings. The P/E ratio is derived by dividing the current stock price by the dollar amount of earnings per share.
What that tells you, in simple terms, is how much investors are willing to pay for those earnings. For instance, a P/E ratio of 20 means the investor is paying $20 for $1 of earnings for each share they hold.
The long-term average P/E ratio of the S&P 500 is $14.75. If a stock has a P/E ratio that’s much higher, it can mean that investors believe earnings for that company will be higher in the future.
Of course, if share prices in general fall dramatically in a short period of time, say in a market crash, while earnings remain the same, that will drive the P/E ratio of the market much higher, too.
Meanwhile, if stock prices go very high, for instance in a bubble, while earnings don’t rise at the same rate, then P/E ratios fall. The market can be said to be overpriced relative to earnings.
Because of this problem, it’s usually best to use P/E ratios only to compare two similar stocks in similar industries at the same time.
Investors use a lot of variations on the idea of the P/E ratio, such as the price-to-earnings-growth (PEG) ratio and price-to-book-value.
Each shows a different flavor of the same idea — how much is the company worth to others right now, and is the price fair?
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