The price/earnings (P/E) ratio is of particular interest to investors in public businesses. The P/E ratio gives you an idea of how much you’re paying in the current price for stock shares for each dollar of earnings (the net income being earned by the business). Remember that earnings prop up the market value of stock shares.
The P/E ratio is, in one sense, a reality check on just how high the current market price is in relation to the underlying profit that the business is earning. Extraordinarily high P/E ratios are justified when investors think that the company’s EPS has a lot of upside potential in the future.
The P/E ratio is calculated as follows:
Current market price of stock ÷ Most recent trailing 12 months diluted EPS = P/E ratio
If the business has a simple capital structure and does not report a diluted EPS, its basic EPS is used for calculating its P/E ratio.
For the business example shown in the following figure, the capital stock shares are trading at $70, and its diluted EPS for the latest year is $3.61. (Remember that diluted EPS applies to businesses with complex capital structures; basic EPS applies to businesses with simple capital structures.)
Stock share prices of public companies bounce around day to day and are subject to big changes on short notice. To illustrate the P/E ratio, use the $70 price, which is the closing price on the latest trading day in the stock market.
This market price means that investors trading in the stock think that the shares are worth about 19 times EPS ($70 market price ÷ $3.61 EPS = 19). This P/E ratio is then compared with the average stock market P/E to gauge whether the business is selling above or below the market average.
Over the last century, average P/E ratios have fluctuated more than you might think. Also, P/E ratios vary from business to business, industry to industry, and year to year. One dollar of EPS may command only a $12 market value for a mature business in a no-growth industry, whereas a dollar of EPS for dynamic businesses in high-growth industries may be rewarded with a $35 market value per dollar of earnings (net income).
