In its simplest form, the P/E ratio is a measure of how much investors are willing to pay for a company’s stock relative to its earnings per share (EPS). The formula for calculating the P/E ratio is as follows: Price Per Share / EPS = P/E Ratio. For example, if Company A has a stock price of $20 and an EPS of $2, its P/E ratio would be 10 ($20/$2).
P/E ratios can tell investors whether a company’s stock is overvalued or undervalued because it provides insight into how much money investors are willing to pay for its future earnings. Generally speaking, companies with higher growth potential tend to have higher P/E ratios because they’re seen as more desirable investments. On the other hand, companies with lower growth potential typically have lower P/Es because they’re seen as less attractive investments. That said, there are certain industries where higher or lower ratios may be considered normal—so understanding what constitutes “normal” in your industry of choice is essential when interpreting the data.
A high or low PE ratio doesn’t necessarily mean that one company is better than another—it just reflects how much investors think each company will grow in the future. Generally speaking, if two companies have similar EPS figures but one has a higher PE ratio than the other, then that could indicate that investors believe it will experience faster growth in the future and is therefore more desirable as an investment opportunity.