The P/E ratio, or the price to earnings ratio, is one of the simplest and most popular metrics for evaluating stocks.
The P/E ratio compares the stock’s current market price with its most recently reported earnings per share. The price of the stock is then evaluated as a multiple of the earnings that each share is nominally entitled to.
It thereby allows for a very simple and broadly-applicable metric for evaluating and comparing stocks, yet one which cuts to the very core of equity valuation.
The Simple Logic Behind the P/E Ratio
The simple logic that underpins the usefulness of the P/E ratio as a metric for evaluating stocks is based on the idea that the price of a stock should reflect the expectations of future earnings that the owner of that stock is entitled to.
For example, if a company is expected to earn $5 per share this year, and then close all operations and disburse the earnings, then it is logical to imagine that each share should be worth up to $5.
This rough method of valuing shares becomes more complicated as you add additional years of projection into the future and some method for discounting future earnings the longer out they are projected to occur, but the same principle applies.
High and Low P/E Ratios
With the simple logic that underpins the P/E ratio metric in mind, we can see how stocks with a high P/E ratio can be considered over-priced, while those with a low P/E ratio will be considered under-priced.
While this simple reasoning is often effectively applied by traders, the issues involved are usually more complex and nuanced.
Some stock’s may have a high P/E ratio that is justified by the expected growth of future earnings relative to current ones, while others may have low P/E ratios that are justified by weak prospects for future competitiveness.
The P/E ratio is a versatile metric used by traders for a number of different reasons.
The particular strength of the P/E ratio is in identifying potential trades by looking for over- or under-priced stocks relative to their earnings, which then require further investigation to identify whether the aberrant P/E ratio is justified or not.