If there is one number that people look at than more any other number, it is the â€œPrice to Earning Ratio (P/E)â€. The P/E is a ratio that investors throw around with confidence as if it told the complete story. Of course, it doesn’t tell the whole story (if it did, we wouldn’t need all the other numbers.) The P/E looks at the relationship between the stock price and the company’s earnings.
The P/E is the most popular stock analysis ratio, although it is not the only one you should consider. You calculate the P/E by taking the share price and dividing it by the company’s EPS (Earnings Per Share that we saw above)
P/E = Stock Price / EPS
For example: A company with a share price of Rs.40 and an EPS of 8 would have a P/E of: (40 / 8) = 5
What does P/E tell you?
Some investors read a high P/E as an â€œoverpriced stockâ€. However, it can also indicate the market has high hopes for this stock’s future and has bid up the price. Conversely, a low P/E may indicate a â€œvote of no confidenceâ€ by the market or it could mean that the market has just overlooked the stock. Many investors made their fortunes spotting these overlooked but fundamentally strong stocks before the rest of the market discovered their true worth.
In conclusion, the P/E tells you what the market thinks of a stock. It tells you whether the market likes or dislikes the stock. If things are vague and unclear to you, do not worry. The next ratio will make everything you read till now make sense.