The
price/earnings (P/E) ratio is a measure used by investors to tell whether
a stock is underpriced or overpriced.
The P/E ratio relates a firm's current market price to its net
earnings for the past year. The earnings of a firm are considered a good
indicator of the firm's worth. A stock's current market price indicates the
value that investors assign to it based on their beliefs about the company's
current and future earnings. Therefore, a stock's current market price is
usually greater than its current earnings per share. If a stock is trading with
a P/E ratio greater than 20/1, it often means investors expect strong future
growth in earnings of that corporation.
Calculating a P/E ratio is fairly simple to do. You simply take a
firm's current market price and divide it by net earnings per share for the last
12 months.
P/E ratios for most stocks are listed in the business section of
your local paper.
Now that you know what a P/E ratio is and how to calculate
it, let's talk about the importance of the P/E ratio for
investors.
