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 todayâ€™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 â€“ 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.

# Price-to-Earnings (P/E) Ratio

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