P/E ratio is a valuation ratio which is calculated as the share price compared to the earnings per share of the stock. This is also known a price multiple or the earnings multiple.
The price earnings ratio is an important tool in the arsenal of a stock market investor as he can then predict the stock market price of a particular stock.
Let us take an example of how the price to earnings ratio is calculated.
Assume the stock is ABC and the share price is 100 dollars. The earnings per share of the stock for the last 12 months is 4.00 dollars. Based on the formula, the P/E ratio of the stock ABC will be 100/4.00 = 25.
Now this number 25 in itself can not tell you anything however you can use this to compare that with the stocks of the companies which operate in the similar industry and also use this to predict the stock price in future.
Here is how you can use the P/E ratio.
Assume the stock ABC with a P/E ratio of 25 is in the oil industry then we need to check the P/E ratio of other stocks that are in the oil business. In general the high PE ratio will tell that this stock has a higher earning potential than the other oil industry stocks which have lower PE ratio.
Another thing to note is that if you have the predicted future earnings per share then you can use the PE ratio to predict the stock price. Let us see that in the context of the stock ABC. Assume that the EPS or the earnings per share in future will be 5.00 dollars. Also assume that PE ratio will be the same that is 25.
Now the price of the share will be 125 (25x5). This will give you the answer to question that if this stock is a good buy right now or not. If the current price is hundred based on the trailing P/E ratio then definitely the stock is a good buy.
A lot of investors call this as multiple which shows that the amount that the investors are ready to pay for each dollar of the earnings.
As a stock market investor it is not good to base your decision on only one ratio but price to earnings ratio is definitely a good way to shortlist that initial set of stocks that you would like to invest in.