The price/earnings ratio is a common financial measurement that investors use to evaluate whether a stock price is a good value. The P/E ratio shows how much the stock market values a stock's earnings, which are a company's profits, expressed per share. The P/E ratio is calculated simply by dividing the current price-per-share by the current earnings-per-share. With P/E ratios, there is no absolute judgment over good or bad, but stocks with lower P/E ratios are considered "cheap" stocks, regardless of what the stock price indicates.
A P/E ratio is not automatically good or bad since investors often consider the industry and additional factors. A low P/E ratio can indicate the stock is a bargain or does not expect much growth though, while a high one can signal the stock is expensive or expects high growth.
To get the P/E ratio, divide the stock price by the reported earnings-per-share. If a company's stock is $5 and it reported earnings of $1 a share last year, it has a P/E ratio of 5. The ratio tells investors how many years it will take a company to generate enough value to cover the cost of the stock at the current price, assuming its earnings won't change. In this company's case, it would take five years to buy back its shares.
A stock's value is directly related to its ability to generate revenue, and the P/E ratio is used to judge the earning power of the company, regardless of the share price. If one stock is priced $100 and the other priced $10, the P/E ratio is used to give investors a tool to compare these two stocks. If the $100 stock has a P/E ratio of 6 and the $10 stock has a P/E ratio of 8, the $100 stock is cheaper because the investor is only paying $6 for every dollar of earning, as opposed to $8 per dollar of earning for the $10 stock.
Like anything "cheap," a stock with a low P/E value may be a bargain or it could be a dud. A low P/E ratio can indicate that the market expects little growth in a company's earnings. High P/E ratios can mean the market expects growth or that its share price is too expensive. Investors can weigh other statistics, like price-to-cash-flow or price-to-sales, along with the strength of the economy, the industry and the company's history. P/E ratios vary across companies, regardless of their industries, but some more established industries with little growth potential tend to have low P/E ratios, while companies in growth industries tend to have higher P/E ratios.
The P/E ratio is usually calculated as a "trailing" ratio by using the past 12 months of earnings. However, analysts can calculate a "forward" P/E ratio by using a projected earnings-per-share. A high forward P/E ratio can mean that investors believe a company's earnings will grow quickly or it could be a sign that investors have gotten too exuberant for the stock. Because it's based on analyst projections, the forward P/E ratio can be flawed or overly optimistic.