Understanding The P/E Ratio

Investors often want to compare how the share price of one company compares to that of another. But just looking at the stock price is like comparing apples to oranges since companies have different numbers of shares outstanding, and even if they had the same share float, companies operate in different industry segments or are at different stages in the corporate life cycle. Fortunately, financial analysts have developed a number of tools for such purposes of comparison. The price-to-earnings ratio, or P/E, the most widely used metric.

Although it is quite a simple indicator to calculate, the P/E can be difficult to interpret. It can be extremely informative in some situations, while at other times it is difficult to parse. As a result, investors often misuse this ratio and place more evaluative power in the P/E than is sometimes warranted.

The P/E ratio measures the market price of a company’s stock relative to its corporate earnings, which can then be compared with other companies. In theory, $1 of earnings at company A should be worth the same as $1 of earnings at a similar company B. If this is the case, both companies should also be trading at the same price, but this is rarely observed in reality. If company A’s stock is trading for $5 and company B is trading for $10, it means the market values company B's earnings at a higher level. This may be a sign that company B's shares are overvalued, but it could also mean that company B deserves a premium on the value of its earnings due to superior management or a better business model. As a rule of thumb, a high P/E suggests that the stock price is relatively high compared to earnings and might point to it being overvalued. Likewise, a low P/E can signal the market is undervaluing these shares. Investors, analysts and corporate managers alike all look to the P/E ratio as an important indicator on how a company is doing relative to others in its industry or to the market more broadly, as well to how it has performed in the past.

In this tutorial, we'll introduce you to the P/E ratio and discuss how it can be used in stock price analysis and, perhaps more importantly, how it should not be used.

If you don't have a solid understanding of stocks and how they trade on the stock market, we also suggest that you check out our Stock Basics tutorial.