What is the price-earnings ratio
The price/earning (P/E) ratio is another measurement that's of particular interest to investors in public businesses. The P/E ratio gives you an idea of how much you're paying at the current price for stock shares for each dollar of earning. Earnings prop up the market value of stock shares, not the book value of the stock shares that are reported in the balance sheet.
The P/E ratio is a reality check on just how high the current market price is about the underlying profit that the business is earning. Extraordinarily high P/E ratios are justified only when investors think that the company's earnings per share (EPS) has a lot of upside potential in the future.
The P/E ratio is calculated by dividing the current market price of the stock by the most recent trailing 12 months diluted EPS. Stock share prices bounce around day today and are subject to big changes on short notice. The current P/E ratio should be compared with the average stock market P/E to gauge whether the business selling above or below the market average.
P/E ratios are currently running high, despite a four-year slump in the stock market. P/E ratios vary from industry to industry and from year to year. One dollar of EPS may command only a $10 market value for a mature business in a no-growth industry, while a dollar of EPS in a dynamic business in a growth industry may have a $30 market value per dollar of earnings or net income.
To sum up, the price/earnings ratio or P/E ratio is the current market price of a capital stock divided by its trailing 12 months' diluted earnings per share (EPS) or its basic earnings per share if the business does not report diluted EPS. A low P/E may signal an undervalued stock or a pessimistic forecast by investors. A high P/E may reveal an overvalued stock or might be based on an optimistic forecast by investors.
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