A price/earnings ratio refers to a comparison of share price to earnings. The price deals with the cost of each share while the earnings describes the amount each share pays out to investors. In most cases, higher price/earnings ratios indicate future growth of the company.
How to Calculate Price/Earnings Ratios
To calculate a company's price/earnings ratio, divide the earnings per share by the market value. For example, if a stock trades at $50 per share and its earnings amount to $2 per share, its price/earnings ratio is 25.
Numbers Used to Calculate the Price/Earnings Ratio
Most valuations use a trailing calculation of the earnings per share. In other words, the average earnings per share is calculated using the totals for the previous four quarters (one year).
Why the Price/Earnings Ratio Matters
The price-to-earnings ratio indicates the level of confidence placed in the company behind the stock. However, this is not always the case. For example, companies that see few fluctuations, such as utilities, often feature low price/earnings ratios.
Additionally, some investors specifically target companies with low P/E ratios. They believe those stocks represent undervalued companies and untapped potential. It all depends on the investor's strategy and values when choosing to buy and sell stocks.
Average Price/Earnings Ratios
The average P/E ratio on the S&P 500 index is 15, according to Forbes. However, as mentioned above, averages vary depending on how this ratio is calculated and by whom.
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