How Investors Determine the Price to Earnings Ratio
Investors can estimate whether a stock is overpriced or underpriced by calculating the price to earnings ratio (P/E). Say an investor has some idea of the value of a stock but he wants to know how the price of the stock compares to its value. The first thing the investor needs to do is remember that the market, not the value of the company itself, determines the stock’s price. Then he can calculate the P/E:
Follow these steps to calculate the P/E:
Check the stock market online or ask your broker what the market price per common share is, and then calculate the earnings per share by following the steps I list in the earlier section Earnings per common share.
Divide the market price per common share by the company’s earnings per share to get the P/E ratio.
In estimating the P/E, investors tend to look toward the future. The company will continue (it hopes) to make earnings over the course of several years, and the market price usually reflects that, being many times higher than the earnings of the company. As a result, you need to view the P/E in terms of what market investors think of the growth potential of the company. A high P/E compared to other companies in the same industry means that investors anticipate high growth, while a low P/E indicates anticipation of low growth or even negative growth. Of course, investors tend to be wrong . . . a lot . . . so use caution when using the P/E. Using other metrics, particularly those related to the balance sheet, can help add more context to this measure.