Understanding the Importance of the Price/Earnings (P/E) Ratio

People who own stock in a company (public or private) want to know one thing above all else: Which way is the share price headed? Without reaching for the crystal ball, there is a financial ratio that can give you some clues on whether shares are cheap or expensive.

The Price/Earnings ratio (P/E) is the unit pricing method for stocks. Ever start to buy a big can of tuna (Ok, I really love tuna) thinking you would get the best deal only to find that the price per ounce (let’s call it the “P/O”) was about twice as high as the P/O of the little six-ounce can? Unit pricing has made grocery stores safe for those of us who can’t do long division in our heads, and the P/E lets us compare stock prices in the same way. To compute it, you divide the price per share by the company’s earnings per share (EPS). The P/E is the price of a dollar of earnings (profits). For example, if you buy shares of a stock that has a P/E of 30, you pay $30 for each $1 of profit.

What you are really buying when you buy a share of stock is the right to a portion of a company’s future profits. But since a “share” of a company is not defined (it could represent one-half ownership of a company, or one-five-billionth ownership, or anything in between), the price per share is meaningless. The P/E converts price per share into the cost of a dollar’s worth of annual profits. That’s a much more meaningful number.

For example, let’s imagine two similar companies, one selling for $100 per share and one for $50 per share. Would the $50 company be a better buy? (If you said you don’t know, you’re with me so far. If you thought “yes,” reread the previous paragraph.) But let’s suppose that the $100 company is earning $5 per share and the $50 company is earning $2 per share. That would give the $100 company a P/E of 20 and the $50 company a P/E of 25. Now which is the better deal (investment)?