The price-to-earnings ratio is an indicator which can be used to determine the current and future profitability of a company. It shows the relation between a company’s per-share profit and its stock price.
The P/E ratio is calculated by dividing a stock’s price by the current or estimated future earnings of the company which issues it.
If the current price of a stock is 60 francs and the company that issued it last declared earnings equal to 8 francs per share, the stock would have a 7.5 P/E ratio.
P/E ratios can be used to determine how far a company’s stock prices exceed its earnings. The P/E ratio also reveals how long it will take for a stock to pay for itself at current company earning rates.
In the example above, the stock price is 7.5 times higher than the company’s actual per-stock earnings. At this ratio, you can expect your 60-franc investment in that stock to be paid back within 7.5 years.
So calculating P/E ratios can tell you a lot about the relationship between the cost of a stock, and the returns you can expect to earn. However, a high price-to-earnings ratio is not a clear signal to sell your shares, just as a low price-to-earnings ratio alone does not present enough reason to buy stocks.
While calculating P/E ratios is easy, applying them to trading is somewhat more complicated. Because company profits are influenced by many different factors, there is no guarantee that earnings will remain constant in the future. Changes within a company, the competitive landscape, consumer behavior and market fluctuations all influence company earnings.
Because of this, it is important to compare current price-to-earnings ratios with past price-to-earnings ratios in order to get a clearer picture of long-term company performance. It’s also helpful to compare the price-to-earnings ratios of multiple companies within similar industries.