The price to earnings ratio, or P/E as it's more commonly known, is one of the most useful metrics an investor has in his or her toolkit when valuing a company. It is simply the price per share divided by the total earnings per share (EPS).
What is the usefulness of the P/E ratio?
The P/E ratio gives investors the ability to compare, ceteris paribus, two companies in the same market segment. The idea here is that for two companies with roughly similar business models, it they should have the same cost of sales and difficulties in growing revenues. Thus, their earnings are roughly comparable. Finding out the relative price of each company gives an estimate if one or the other is overvalued.
Things You Will NeedCalculator, pen and paper, Excel, or just Google Finance!
Step 1To calculate the price-to-earnings (P/E) ratio, the steps are quite simple. After you find a company, write down the price per share. Then find the earnings per share, usually given as its own separate metric. Divide the two and you'll find the P/E ratio!
Step 2Of course, most online stock tools will give you an estimate of the P/E ratio for a particular stock. Google Finance and Yahoo Finance are great options. However, it is important to know what estimate of earnings per share you are using (see below in Tips & Warnings).
Step 3With the P/E ratio in hand, you will now need to find some competitors. Write down any names that come to mind as being a competitor to your chosen company. For example, if you picked Citigroup (C), then common competitors might be Bank of America (BAC), JPMorgan (JPM), Goldman Sachs (GS), or Morgan Stanley (MS). All of these companies are in the investment banking sector, and thus get their earnings in similar ways.
Step 4Instead of manually figuring out a company's competitors, you might just want to use Google or Yahoo Finance again. In Google, the competitors are listed below the stock chart, while in Yahoo you will need to click on the "Competitors" tab in the left sidebar once you enter a stock ticker to get a quote.
There you have it! A calculated P/E ratio for your chosen company, along with some competitors to compare it along with. Basically, if your company has a higher P/E ratio, then it is relatively overvalued compared to its competitors. If it has a lower P/E, then it could be said to be undervalued. However, don't use this by any means as the sole determinant for an investment decision; the P/E ratio is only useful as a small piece of the puzzle.
Tips & Warnings
One caveat: Google Finance and Yahoo Finance usually use trailing twelve months (TTM) earnings to calculate their earnings per share. In most cases this is okay, but if your company is relatively new and still shows losses, then you won't be able to calculate earnings per share. If this is the case, then go ahead and use forecasted earnings instead.