Price-to-Earnings Ratio (PE Ratio)
Definition of 'Price-to-Earnings Ratio (PE Ratio)'
The price-to-earnings ratio, or P/E ratio, is a widely used measurement to evaluate a stock’s value. By comparing a company’s stock price to its earnings per share, it illustrates how much investors are willing to pay for a company’s earnings.
TheStreet Explains ‘Price-to-Earnings Ratio (PE Ratio)’
The equation for the P/E ratio is the current share price divided by the annual earnings per share. Investors sometimes refer to the quotient as the “multiple,” meaning that investors are willing to pay X amount for each dollar of a company’s earnings. A stock with a higher multiple is considered to be more expensive, and a stock with a lower multiple is seen as less expensive. The word "expensive" in investing terms has a slightly different definition than it does in everyday terms. In the world of investing, expensive means that a stock price is high relative to the company's earnings -- or to put it another way, that the stock has a high P/E ratio or multiple. A share's multiple can be used to compare a company's share price to its historical prices, against other companies in the same industry, against the industry as an aggregate or against the market as a whole.
Different industries have different multiples because different industries have different growth potentials. Normally, a technology company will have a higher multiple than a utility company because the technology firm has higher growth prosects than the utility company. Investors are willing to pay more for the higher growth because they expect that the company's earnings will grow and therefore the price of the stock will grow as a multiple of the earnings increase. P/E ratios are often used to determine if a market, industry or company is over or under valued. In 1974, for instance, all industries had an average P/E of 11, according to BusinessWeek. On Jan. 1, 2015, the figure was 20, nearly double.
To measure earnings in the denominator of the P/E ratio, investors use either past or future earnings. When investors use a company’s past four quarters of earnings, the P/E ratio is referred to as “12-month trailing,” to indicate that the multiple is based on actual, past results. Ratios that use analysts’ estimates of future earnings streams are referred to as based on “forward earnings.” P/E ratios can differ substantially depending on how steady earnings at a company are growing. It’s important when making comparisons between companies and industries to be sure you’re comparing apples to apples and consistently using either past or future earnings numbers.
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