How to Calculate Price Earnings Ratio

Price-earnings ratio, also known as P/E ratio, is a tool that is used by investors to help decide whether they should buy a stock. The P/E ratio tells investors of a stock how much they have to pay for every $1 of earnings. A low P/E ratio is attractive in the sense that one pays less for every every $1 of earnings. At the same time, companies with higher P/E ratios generally expect higher earnings growth in the future than companies with low P/Es.^[1]

Edit Steps

Edit Part One: Calculating the Ratio

Know the formula. The formula for calculating P/E is simple: The market value per share divided by the earnings per share.
- Market value per share is simply how much it costs to buy a share of any publicly-traded company on the stock Market. On August 23, 2013, for example, it cost $40.55 to buy one share of Facebook.^[2]
- Earnings per share is calculated by taking a company's net income over the last four quarters, subtracting any dividends, and then dividing the rest by the number of shares outstanding:

Try an example. Let's try an example using a real publicly-traded company as an example. Take Yahoo!, for example. As of August 23, 2013, Yahoo!'s stock was trading at 27.99.
- We have the first part of our equation, the numerator, or 27.99.
- We'll need to calculate Yahoo!'s EPS. You can just type "Yahoo!" and "EPS" into a search engine if don't want to calculate EPS yourself. As of August 23, 2013, Yahoo!'s EPS was $.35 per share.
- Divide 27.99 by .35 to get 79.97. Yahoo!'s price-earnings ratio is approximately 80.

Edit Part Two: Using the Ratio

Compare the P/E to other companies in the same industry. P/E by itself is useless; the number doesn't tell you anything unless you compare it to other companies' P/Es in the same industry. Companies with lower P/Es are considered "cheaper" to buy — for how much they earn, their stock price is cheaper — although this analysis alone won't tell you whether to buy a company.
- For example, Stock ABC is trading at $15/share and has a P/E of 50. Stock XYZ is trading at $85/share and has a P/E of 35. It's cheaper, however, to buy Stock XYZ, even though it's share price is higher than Stock ABC's. That's because with Stock XYZ, one pays $35 for every $1 of earnings, whereas with Stock ABC, one pays $50 for every $1 of earnings.

Know that P/Es can be affected by investors' future expectations of a company's value. Although P/E is often thought of as an indication of how the company has been priced in the past, it's also an indication of what investors think of its future. That's because stock prices are a reflection of how people think a stock will perform in the future. Therefore, companies with high P/Es is a sign that investors expect higher earnings growth in the future.

Know that debt or leverage can artificially lower a company's P/E. Taking on a bunch of debt generally increases a company's risk profile.^[3] That being said, of two companies with the exact same operations, trading in the same sector, the company with a moderate debt load with have a lower P/E ratio than the company with no debt. Keep this in mind when using P/E as a tool for diagnosing a company's vitals.