What is the Price to Earnings Ratio? And Why is it Important in Making a Stock Investment

One of the best things about having an accounting degree was being taught how to figure out financial ratios from an income statement or balance sheet. However, you do not need an accounting degree to learn how to use ratios to decide whether you want to invest in a company or not. This article will teach you how to figure out the price to earnings ratio, and why knowing this ratio can help you in making an investment decision.

When studying a financial statement deciding whether you should invest or not; one useful ratio to make this decision is the price to earnings ratio. On the balance sheet, when a company reports the value of their stock shares, they go by book value. However, the balance sheet is only a snapshot of the business, at that particular moment in time.

It's important to understand that one factor which drives market value of a company's stock are its earnings. By using the price to earnings ratio, you'll get an idea of exactly what the current price for stock shares are, per dollar of earnings.

In other words, the price to earnings ratio will reveal to you whether the price of the stock is over inflated, undervalued, or just right; based on the profit the business is earning. If you find a company which has a high price to earnings ratio, this is only acceptable if the company is looking to make some big, profitable, moves in the near future.

To calculate price to earnings ratio, you divide the current market price of the stock by the most recent consecutive 12 months diluted earnings per share.

The stock market can be a very volatile place. Therefore, it is likely that stock prices will go up and down daily and can change drastically in the matter of a few minutes. You can determine whether the current price to earnings ratio is above or below the current market average. You can accomplish this by comparing the company's price to earnings to the average stock market price to earnings.

The P/E is dependent upon industry and can change from year to year. If a company is mature, and it is involved in a no growth industry, one dollar may fetch only a $10 or less market value. Conversely, if a company is involved with the high growth industry, it would not be uncommon for the company to have $30 or more per dollar of earnings, of net income.

To summarize: P/E is calculated by dividing the current market price of the capital stock are provided by its most recent 12-month diluted earnings per share, or basic EPS if the company has not, or does not, report its diluted EPS.

A low P/E can be an indicator that investors don't have confidence in the company or it could be an undervalued stock. If the price to earnings is high, it could mean the stock price is artificially inflated. It could also mean investors have a lot of confidence that the company is set to do big things.

Price to earnings should only be one ratio in your arsenal. Don't let this ratio be the lone determinant of whether you invest in that company or not. The price to earnings ratio is a good starting point, but you should do some further digging and more number crunching, before you invest in any company.