Why P.E ratio is Important?

P/E ratio simply stands for Price to earnings ratio. The P/E ratio shows whether the stock is under/overvalued, it is one of the methods to find the stock is over/ undervalued in value investing. The P/E ratio measures the relationship between a company’s stock price and its earnings per share of stocks.

The P/E ratio is calculated by dividing a company’s current stock price by its earnings per share. Earnings per share (EPS) is the company’s total profit divided by the total number of shares in the stock.

Let’s say a company has a net income of $10 billion, it pays $2 billion in preferred dividends, and it has $4 billion shares outstanding. Here is how we’d calculate its EPS:

Earning per shere (EPS) = ($10 billion-$4 billion)/$2 billion shares= $3 per share.

Through the value of EPS, we can now calculate the P.E ratio of the stock. If the market value of the stock is $30 per share now P.E ratio is 30/3 = 10.

Let say the market value of the stock is $50, now P.E ratio is 50/3 = 16.7

If the market is in the peak value, the price of the stock has higher value then the P/E ratio should higher, let say the P/E ratios 40, 16 5, here the P/E ratio of 40 is really high, a P/E ratio of 5 is really low, and a ratio of 16 denotes the average.

Formula
PE ratio =  Stock Price/Earnings per share

Value investors can use the P/E ratio to help find undervalued stocks.