Price Earnings Ratio (P / E Ratio) :

The price earnings ratio or p / e ratio provides information about the earnings of a company in relation to the stock rate respectively the market capitalisation of a company. The p / e ratio is interesting in order to get information about the how much profitability you get for your dollars. A rule of thumb implies that a p / e ratio of 15 is optimal a p / e ratio above 20 implies that the company is too expensive or we could say overvalues and a p / e ratio under 10 is too cheap respectively implies that a company is often in trouble.

Ways to calculate the p / e ratio:

For example, if a stock is trading at $24 and the earnings per share for the most recent 12 month period is $3, then stock A has a P/E ratio of 24/3 or 8. Put another way, the purchaser of the stock is paying $8 for every dollar of earnings. Companies with losses (negative earnings) or no profit have an undefined p / e ratio (usually shown as Not applicable or “N/A”); sometimes, however, a negative p / e ratio may be shown.

Another way to calculate the p / e ratio would be:

For example if the value of the market capitalisation of a company is 1 million $ and the total annual earnings amount to 100000 $ the p / e ratio is 10.

But we have to be careful by using the p / e ratio because of several reasons.

1. When the p / e ratio of a company is very low it´s often the case the earnings of a company are going to fall and drag the low p / e ratio below.

2. The values the price earnings ratio is calculated on are mostly values from the past which don´t reflect the current situation of the company anymore.

However what is the p / e ratio good for ?

The p / e ratio is always interesting when we want to have a quick and dirty look at the current estimation of a company. At the times of the dot-com bubble in the year 2001 we could see many estimations where the p / e ratio was above 100. That means that the expectations to a company are very high, but the real earnings of a company didn´t correspond this high expectations, yet (in the most cases it´s also not very likely that they ever will). So the p / e ratio can give us quick information weather a stock of a company is undervalued or overvalued.