Defining Price/Earnings Ratios

Price Earnings Ratio pic
Price Earnings Ratio
Image: beginnersinvest.about.com

An active Wharton fellow and the former division manager of Pepsi-Cola Buffalo Bottling Corp., Darin Pastor is the chairman of Capstone Financial Group, Inc. An investment manager with a diverse portfolio of companies under his management, Darin Pastor considers Price/Earnings ratios when making buy-sell decisions.

Price/earnings ratio (P/E ratio) is a measure of a company that takes into account the security’s share price and its earnings per share. It is calculated by dividing a company’s current share price by its earnings per share declared in the most recent financial year. If a company’s share price is $40 and its recent earnings per share were $2, then the company’s P/E ratio would be 20.

To investors, the ratio is an indicator of how much market traders will pay for a dollar of earnings from the company. For a company with a P/E ratio of 20, investors are willing to fork out $20 in exchange for $1 in current earnings.

A high P/E ratio is an indication of investor confidence in a company, while a low P/E ratio shows that investors may be skeptical of the company. For a better picture of the market, a company’s P/E ratio should be compared to those of other companies in the same industry.

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