What Is a Price-To-Earnings Ratio?

Price-to-earnings ratio is a common method used to calculate the intrinsic value and growth of a publicly traded company as compared to others in the market. It is often used to base investing decisions on for both institutional investors and private investors. Also known as P/E or multiple, a price-to-earnings ratio is calculated by taking a publicly traded company's market capitalization and dividing it by its total earnings for any current fiscal year. Market capitalization is a number arrived at by taking a company's current share price per share, and multiplying it by the number of shares the company has issued, or that are considered outstanding, meaning held by investors of various types in the firm.

The value of a price-to-earnings ratio must take several factors into account when trying to evaluate a company as a worthwhile investment. One of the first important considerations is the actual size of the company's market capitalization. Small capitalization companies as a general rule have a market capitalization of between $300 million - $2 billion US Dollars (USD), mid cap companies $2 billion - $10 billion USD, and large cap firms over $10 billion USD. While a small cap, mid cap, and large cap company may all have nearly identical price-to-earnings ratios if their earnings rise respective to their capitalization size, small cap firms are considered a greater risk than more stable, dominant firms. Small cap firms with a high P/E ratio also have the potential to grow much more quickly than established large cap firms that have already saturated the market place, but along with this increased growth potential comes increased risk of failure and volatility.

Another common way to calculate price-to-earnings ratio is to take the current value of a company's stock price, known as the market value or market price per stock share, and divide it by earnings-per-share (EPS). Earnings-per-share is defined as dividing the the net income a corporation has had in the most recent year by the total number of outstanding shares of common stock. Variations on P/E ratios are often derived by using projections of company earnings in the coming year in the calculation, to see where the company is headed, known as forward P/E, or using two past fiscal quarters and two fiscal quarters coming up to determine expected changes in P/E.

Financial ratio calculations like price-to-earnings ratio have limited value in predicting the future course of a company, but become increasingly valuable as they are compared against other data. Once a price-to-earnings ratio value has been determined, it is best to compare it both against historical P/E levels within the company to see how it has changed, and against similar companies of similar size and producing the same goods or services in the industry. High price-to-earnings ratio numbers generally indicate that the investors in the company are expecting it to have strong growth in the future and this is reflected in high stock prices. This is the main reason P/E is often referred to as multiple or price/earnings multiple, as it is an indicator of what investors are willing to pay for a share of stock. A price-to-earnings ratio of 25 suggests that an investor is willing to pay $25 USD for every $1 USD in current earnings that the company has.