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Stocks and Investing: How to Calculate a Price to Earnings Ratio

By Edited Nov 13, 2013 2 2

What is a Stock Worth

Purchasing stocks from the Stock Market is not like purchasing items from a supermarket. For one thing, the price of a stock is likely to change from minute to minute, while the price of an item at the supermarket is only likely to change if it is on sale. In addition, it is pretty easy to determine whether or not you are getting a good price from a particular supermarket, all you have to do is compare their prices with other supermarkets in the area. But, with the prices of stocks changing moment by moment, how do you determine whether a stock price is a good value or not? The Stark Market is the only place I can think of where a $50 stock can actually be a better value than a $5 stock. But how can you know? A good start is by learning how to calculate a stock's "price to earnings" ratio. 

When you purchase stock in a company, how do you know what it is worth? A company is valued on the basis of their earnings (profits), future expected earnings and growth. Determining the valuation of stocks requires knowledge of the price to earnings ratio. In order to determine if a particular stock is a good value or not you'll have to know how to calculate its P/E ratio.

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EPS - Earnings per Share

The first thing you must know when valuing a stock is its "earnings per share" (EPS) value. The EPS are a portion of a company's profit allocated to one share of stock or the earnings returned on the initial investment amount.  The EPS equals the amount of money a shareholder would be eligible to recoup in the event of liquidation. The higher the EPS the better it is for a stockholder.

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To determine a company's EPS you will need to know three things; 1) the company's net earnings, 2) the preferred dividends and 3) the company's outstanding shares. You can find this information in a company's annual report (the report prepared for shareholders outlining a company's financial performance). Most publically traded companies include their annual reports (and other reports) on their websites. You can also do a search of a company's filings made to the Securities and Exchange Commission (SEC).

The Earnings per share is calculated by dividing a company's net income (minus preferred dividends) by the average shares outstanding.

P/E - Price to Earnings

The price to earnings multiple is the real value of the stock and represents how many times more than the earnings the Market is willing to pay for the stock. Price to earnings is determined by dividing the amount a stock trades for by the amount a company earns per share (EPS). 

Stock price divided by the EPS equals the P/E ratio. 

The P/E multiple represents the true value of the stock, a valuation ratio of a company's current share price compared to its per-share earnings. One way to determine whether the price of a stock is a good deal or not is to compare the P/E stock multiple to that of the company's competitors. 

So, if a stock price is $5 but the P/E multiple is $0.20, while the price of another stock is $50 but their P/E multiple is $7.50, the best value is the $50 stock.

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Jan 26, 2013 11:59am
For some reason I can never remember how to calculate a price to earnings ratio, so I posted it in a notebook. Thanks for sharing it here, now I have two places to look for it. Thumbs Up!
Jan 29, 2013 8:09am
Thanks SG, I began investing in stocks several years ago and this was one of the first things I learned.
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