Definition: The price earnings ratio, often called the PE or price-to-earnings ratio, is a financial ratio that compares the market value per share with the earnings per share. In other words, it’s a financial measurement that investors can use to evaluate the future cash flows from an investment in relation to the value of the investment. Many investors view this ratio as the amount of money the market is willing to pay for the current amount of cash flows attributed to each stock.
What Does P/E Ratio Mean?
The price earnings ratio formula is calculated by dividing the fair market value per share by the earnings per share.
Thus, there are three main factors that can manipulate the PE of a company: number of outstanding shares, income for a period, and the market price. All else equal, the company can manipulate its PE with two of these factors.
Investors know this fact and can use this equation to calculate past PE ratios or estimate future ones. By using the last period’s ESP and the market value on the date the financial statements were issued, investors can calculate the historical PE ratio. They can also use the market value per share and estimate a future ESP to calculate an expected PE for the next period.
This allows external users to speculate on the future price of the stock as well as estimate the corporate profits in the next period. Many investors believe that companies’ shares with a higher PE ratio, above 25, tend to be overvalued because investors are willing to pay more based on the ratio. Likewise, a stock with a ratio below 8 is often viewed as an underpriced stock.
Either one of these can be good investments, however. A company with a high PE can continue to improve performance and keep increasing its ratio. A company with a low PE often times has an easier time increasing its ratio as a percentage because it’s much smaller.