The potential for a company’s share price to rise and fall often depends on how quickly its earnings are expected to increase. The PE Ratio provides investors with an insight into the financial prospects of a company.

The PE Ratio is calculated as:

Market Value of Share
Earnings Per Share

For example, if a company is currently trading at $52 a share and earnings over the last 12 months were $2.30 per share, the P/E ratio for the stock would be 22.6 ($52/$2.30).

Sometimes, a high P/E Ratio suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E Ratio

The P/E Ratio is sometimes referred to as the multiple, as it shows how much investors are willing to pay per dollar of earnings. For example if a company were currently trading at a multiple (P/E) of 20, the interpretation is that investors are willing to pay $20 for $1 of earnings.

A low PE ratio (E.g. 10) compared to other stocks in the sector or index can also suggest that the stock is undervalued and a good buy. A high PE Ratio (E.g. 50) can indicate that stock is overvalued and should be sold.

But this method has its limitations because the published PE is based on the previous year’s earnings, which is historical, rather than a projected measure of the performance of the company.

Therefore if we had to make a judgement on this fundamental data alone, it would indicate either to buy or sell the stock. However, because we also take other factors into account, such as the dividend yield and the EPS, we may decide to buy a stock with a high PE or continue to own a stock with a PE below the market average.