price-to-earnings ratio
A valuation metric comparing a company's stock price to its earnings per share, used to assess if a stock is over or undervalued.
Example
“The stock had a high P/E ratio of 50, suggesting investors expected strong future growth.”
Memory Tip
P/E = how much you PAY (price) for each dollar of EARNINGS. High P/E means expensive stock.
Why It Matters
The price-to-earnings ratio helps you determine whether a stock is reasonably priced before investing your money. A lower P/E ratio might indicate a bargain, while a higher one could mean the stock is overpriced, which directly affects how much of your wealth you might gain or lose from your investment decisions.
Common Misconception
Many people believe that a low P/E ratio always means a stock is a good buy, but this overlooks the fact that a low ratio might exist because the company has serious problems or poor growth prospects. A high P/E ratio is not always bad either, as it can reflect a company with strong future earnings potential that investors are willing to pay more for.
In Practice
If Company A has a stock price of 50 dollars and annual earnings per share of 5 dollars, its P/E ratio is 10. If Company B has a stock price of 100 dollars and earnings per share of 5 dollars, its P/E ratio is 20, meaning you would pay twice as much per dollar of earnings to own Company B, so investors would need to believe Company B has significantly better growth prospects to justify that higher price.
Etymology
Price (market cost) + to + earnings (profit) + ratio — the proportion of price to earnings.
Common Misspellings
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See Also
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