P/E Ratio Meaning - Formula and Calculation

P/E Ratio Meaning - Formula and Calculation
The P/E ratio is used to compare a stock’s price to its earnings. This ratio is crucial as it helps investors decide if a stock is overvalued, appropriately priced, or undervalued. The P/E ratio is a classic and vital metric, but it is also only a starting point in researching a stock.
Learn more about the meaning of p/e ratio, understand what a good p/e is, the p/e ratio formula and how to calculate it.

00:00 - What is the p/e ratio?
00:19 - Price to Earnings Ratio Formula
00:40 - Earnings per Share Calculation
01:36 - High & Low P/E Ratio
02:05 - P/E Ratio as a tool - Conclusions

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What is P/E Ratio?
The P/E ratio is used to compare a stock’s price to its earnings.
This ratio is crucial as it helps investors decide if a stock is overvalued, appropriately priced, or undervalued.

If you want to calculate the price-to-earnings ratio, then you need to know the company’s price and earnings per share.

To calculate earnings per share, you need to divide the company’s net profit by the number of outstanding common shares.
So, the formula for P/E ratio equals price per share divided by earnings per share.
Now, let’s learn how to calculate earnings per share:

Suppose there are two companies, X and Y, selling the same product. Company X earns $4 million and has 500,000 outstanding shares, whereas Y earns $5 million annually and has 400,000 outstanding shares.

An investor pays $80 per share for X and another investor pays $90 per share for Y.
Using the EPS formula on company X, divide 4 million by five hundred thousand, we get $8. And for Y, divide 5 million by four hundred thousand, and we get $12.5.
So, the P/E ratio of X becomes 80 divided by 8, which is 10. And the P/E ratio of Y becomes 90 divided by 12.5, which equals 7.2.

A higher P/E ratio means that a stock’s price is high relative to earnings and possibly overvalued. Whereas a lower P/E tells us that current stock price is low relative to earnings. While on first glance, a lower P/E ratio suggests a more undervalued stock, higher P/E ratios are often given to companies with better growth prospects that are more attractive for the long-term investor.
The P/E ratio is a classic and vital metric, but it is also only a starting point in researching a stock.