Guest Author - Reshma Vyas
PE (price earnings ratio) is an important investing term to understand as it relates to the theory of equity valuation. A stock's PE is the ratio of price per share to earnings per share.
The PE of a stock is obtained by dividing the market price of a stock by the earnings per share. Analysis of a stock's price/earnings ratio is often used to measure the risk of a stock investment. In academic terms, risky companies would have lower price/earnings ratio, yet there are many growing, startup companies with a very high price/earnings ratio. This would reflect market expectations of high growth opportunities for these young companies. Or to put it another way, it is a way of gauging how much the market is willing to pay to purchase a share of the company's earnings. For example, a company stock has a market value of 40 and has earnings of $2 per share. 40 divided by 2 =20. If the average PE for all companies in this particular sector is 9, then this PE (20) would theoretically be overpriced. Earnings per share can be calculated by dividing the net income by the number of common shares outstanding. EPS is subject to fluctuation.
What PE Isn't
The price earnings ratio is not the same as price to book ratio. The price to book ratio is the market value of a stock in relation to its book value (per share). Book value can be loosely defined as the value or worth of a company in the event of a liquidation; its assets minus liabilities.
PE ratios vary greatly across industry sectors. There are certain sectors such as in science and technology where growing companies will have excessively high PE ratios. Mature companies in the food sector, for example, would have lower PE ratios in comparison. PE is an important factor to consider in stock analysis, but it is one of many factors.