Price-to-Earnings (P/E) Ratio

A quick glance at the information listed about particular stocks on a stock exchange will show you that the price-to-earnings ratio (P/E) is considered one of the most important. Financial analysts rely on the P/E ratio because earnings are what drive dividends and capital gains, and provide the fundamental value of a business.

The P/E ratio compares the market price of the stock to the earnings per share, or the total value of the equity outstanding to the total income after tax.



 

The P/E ratio fluctuates based on the market price of the stock. A high price to earnings ratio suggests that investors think the firm has high growth potential. That is, they will pay more for the share today relative to today’s earnings because they expect higher earnings in the future.  We often call P/E ratios multiples. We say that high-tech firms, those that have higher future potential earnings, trade at higher multiples, than low-growth firms like Xerox.

That being said, the P/E ratio is negatively correlated with the riskiness of a stock. An investor will want to pay less for a stock that has uncertain future cash flows than a stock that is guaranteed to make money. As a result, we pay less today for more risky stocks, and risky stocks should have a lower P/E ratio. This points out a trade off. Think of a lottery. It has a high risk – but a high future payoff if you win. On the other hand, stocks in a company, say Coca Cola, have a low risk but not as much growth. Their P/E ratio will reflect the trade off between risk and future returns.