This article defines Price to Earnings ratio (PE ratio), and explains how it is derived.

We keep hearing about the Price to Earnings, or PE, ratio all the time... When a stock is high, or when it is low, when valuations are stretched, or when there is an attractive entry opportunity - the Price to Earnings, or PE, ratio is always mentioned! Time to understand this much talked about Price to Earnings (PE) ratio, isn't it?

Definition

PE Ratio is the ratio of the market price of a stock to its EPS.

PE Ratio = Market price of the stock / its Earnings Per Share

Let's understand the two components of this formula better, so that we have a better understanding of the Price to Earnings ratio itself.

Market price of the stock

Each company issues shares, or stock. Ownership in a company is represented through shares held, and therefore, all the issued shares together represent the total ownership in the company.

(To know more about shares and ownership of a company, please read "Want to own a company? Buy stock!")

For a public company, the shares are traded on the stock exchange. Thus, the share price is determined in the most democratic way for publicly traded companies - through the forces of demand and supply which are in turn influenced by thousands of people participating in the trading.

This market price is the price people are willing to pay for a fractional ownership interest in the company.

Earnings Per Share

It is also popularly known as EPS. This is the net profit earned by a company divided by the number of shares issued by the company. Thus, this is the portion of the net profit pertaining to each share issued by the company.

Price to Earnings or PE Ratio

Now,

PE Ratio = Market price / EPS

Thus, the PE ratio shows how many times the investors are willing to pay for a company, for each rupee of profit generated by the company.

Example: If the price of a stock is Rs. 600, and its EPS is Rs. 40, its PE ratio is 600 / 40 = 15. This means that investors are willing to pay Rs. 15 for each rupee of profit generated by this company.

Thus, the PE ratio is actually a multiple. That's why it is also referred to as PE multiple at times.

To know how to interpret the Price to Earnings (PE) Ratio, please read "Interpreting Price to Earnings (PE) Ratio".

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