The Reason For Connecting Price to Earnings
Any share price is built on expectations of a company’s future performance. Some of these expectations will be based on fundamentals such as the company’s recent performance, its new product lines, and the prospects for its sector. The rest will reflect prevailing moods, fashions, and sentiment.
By relating share prices to actual profits, the P/E ratio highlights the connection between the price and recent company performance. If prices get higher and profits get higher, the ratio stays the same. The ratio only moves as price and profits become disconnected.
For this reason, when the ratio is higher or lower than normal, we know that recent profit levels are no longer the main factor in pricing. Such an occurrence might be because change is afoot (e.g., investors expect a much better or worse performance next year) or because sentiment is now the dominant factor. Either situation is newsworthy.
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