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What is the Price Earnings Ratio, how is it calculated, and how is it used?


Question: What is the Price Earnings Ratio, how is it calculated, and how is it used?

The price earnings ratio is one of the market value ratios used in financial ratio analysis. It is a very important ratio for publicly traded businesses because it tells investors how much they are paying per share (price) for each dollar of earnings (net income) by the company. In other words, the price to earnings ratio shows how much investors are willing to pay for shares of stock of the company per dollar of reported profit.

If a company is in the growth phase of their business cycle, the price earnings ratio is probably high. This means that their earnings are still relatively low or even negative since they are new in the marketplace and just getting started. Their stock price may be high since investors are trading on the potential of the firm. A price earnings ratio that is too high, however, often means the company carriers a lot of risk.

The average price to earnings ratio for the firms listed on the Standard and Poor's 500 is around 19, as a comparative number.

Mature businesses often have lower price earnings ratios than newer, high growth firms. Sometimes, firms with lower price earnings ratios are seen as safer investments than those with higher price earnings ratios.

Here is the calculation for the price earnings ratio:

Current Market Price of Company Stock/Earnings Per Share of Stock = Price Earnings Ratio

A company's price earnings ratio can change often, even on a daily basis, because the market price of the stock can change. Investors use the price earnings ratio extensively in investment analysis. Different industries, different businesses, and different economic time periods often mean different and varying price to earnings ratios for companies.

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