At its most basic level, the P/E ratio helps you determine how much investors are willing to pay for each dollar a company earns.
The denominator, P, is the current market price of the stock
The denominator, E, is the company’s earnings per share (also called EPS)
The P/E ratio can help you compare two stocks in a similar industry.
Stock A has current price of $12 per share and earnings of $2 per share.
Stock A’s P/E ratio is 6 (you are paying $6 for each $1 of earnings)
Stock B has a current price of $12 share with earnings and earnings of $3 per share
Stock B’s P/E ratio is 4 (you are paying $4 for each $1 of earnings)
However, making a decision to purchase Stock B with this information does not guarantee it’s a better buy. The stock, or the entire stock market, can be overvalued – think Internet stocks in the latest 1990’s. Purchasing a stock just because it’s relatively cheap can be dangerous.
The P/E ratio can help you compare two different stocks within the same industry, but making decisions based on the P/E ratio alone doesn’t guarantee you will find the best stocks.