P/E ratio is the price earnings ratio.  Investors, analysts, companies, and accountants pay a lot of attention to it.  The reason the P/E ratio is so important is because it can be used as a gauge—to compare how the market (the stock buying public) views one company in relation to others.  It gives stakeholders an idea of how the current price (market) for the company’s shares of stock relates to the net income of the business; hence the name: price earnings ratio.

There are whole schools of thought (and college courses) that address P/E ratio, but I can cover some basics here.  Investors drive up the P/E ratio – sometimes to extraordinarily high levels—of companies when they think the company has value and potential.  That may believe earnings will increase or the stock may be that of a highly visible or popular company, or a whole host of other reasons to pay a “premium” for a stock from the vantage of its current earnings per share.  Likewise, some stocks suffer a low P/E ration—again, for many reasons.  Some investors try to seek out stocks with an abnormally low P/E ratio on the belief (or hope) that it (and the price per share) will rise to “normal” levels and earn them a profit.

The P/E ratio will more often than not be provided to you, but here’s how to calculate it if you ever need to:

 

Divide the Current Market Price of Stock

By the Most Recent Trailing 12 Months Diluted EPS

(or the basic earnings per share if the company doesn’t report a diluted EPS)

       

Here’s an example:

 

The company’s shares are trading at $45.  It diluted EPS for the latest year is $2.50.  At this price, investors buying the stock believe the shares are worth about 18 times the company’s diluted EPS ($45 divided by $2.50).  You’ll recall that earlier I said that P/E ratio could be used as a gauge.  The P/E ratio of 18 can be compared to the industry average, the market average, and to other companies to see how investors view the potential value of this company compared to others.