The “P/E” in P/E Ratio is an acronym for price to earnings. This refers to the current price of a common stock for the price (P) and that companies total earnings per share (EPS) for the year (E). To get the P/E Ratio, you divide the current price by the EPS.
For example, let’s say XYZ Corp is trading at $20.00 per share (current stock price) and their EPS is $2.00 per share. By doing the simple division here, we see that the P/E Ratio of XYZ Corp is 10. So what does P/E Ratio signify?
The P/E Ratio signifies exactly how much you are spending for every dollar of earnings that the company achieves. In our XYZ Corp example, you would be spending $10.00 for every $1.00 of earnings that the company has. Basically, if a stock has a high P/E, it is considered to be overvalued and if it has a low P/E, it is considered to be undervalued.
Of course these rules are not hard and fast, but there are many investment professionals who swear by the P/E. As for what constitutes a high P/E versus a low P/E, that number too will vary. I was taught that any P/E under 20 was a good investment and to stay away from stocks that had a P/E of 21 or more. While this served me well when I was a stock broker, again, it was not always an indication of a safe bet or a bet to avoid.
A natural question that I would often get is, “What if a company has no earnings?” If this is the case then a stock will have no P/E as there is no way to do the calculation. Besides, if a company is not making any money, then don’t you think that it is only a matter of time before they go under?
You can ask your financial advisor more about what the P/E of a stock means to your portfolio, but don’t be surprised if their numbers are different from mine. As stated earlier, I learned about P/E Ratios one way and that is why my numbers are based on 20, but that is not always going to be consistent. What will be consistent though is the fact that the P/E Ratio remains one of the oldest tools used to measure the attractiveness of investing in a certain common stock.
Source: Investopedia, P/E Ratio Introduction, Investopedia.com