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Price-Earnings Ratio: Definition, Formula & Analysis

Instructor: Ian Lord

Ian is a real estate investor, MBA, former health professions educator, and Air Force veteran.

Investors can use the price-earnings ratio as one method of evaluating different stocks. We will discuss the definition and formula of the P/E ratio, as well as how it is used to analyze investments.

Price-Earnings Ratio

Sam has a multitude of methods for evaluating his next stock purchase, but his favorite is based on answering one simple question. How much does he have to invest in order to gain $1 of that company's profit? The price-earnings ratio answers this question and offers a means of comparing stocks against each other. Let's see how Sam uses this ratio in his investment selection.

The price-earnings (P/E) ratio takes the current share price and divides it by the earnings per share of the company over the last year. It shows how much investors are willing to pay in order to gain $1 of a that company's earnings. Online stock quote sites will list this information, but also automatically show the current P/E ratio. Investors wishing to double check this number use the formula:

Share Price / Earnings Per Share = Price-Earnings Ratio

Sam's got his eye on investing in the ABC Widget Company. Shares of ABC are currently trading at $32 per share. Over the last 12 months the company reports earnings of $2.10 per share. Using the P/E formula below we see:

$32 / $2.10 = 15.24 P/E ratio

Investor Analysis

So what does this number actually mean to Sam? The first thing the P/E ratio tells Sam is that each dollar of profit he receives from that company will cost him $15.24. With that knowledge in hand Sam can compare ABC against benchmarks. The S&P 500 index is one such benchmark and the P/E ratio can be calculated for the index as a whole. If the P/E ratio was 18 for the index, then that tells Sam that the ABC Widget Company is undervalued compared to the rest of the market.

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