Price-to-Earnings (P/E ratio) measures the ratio of a stock's current price to the earnings per share. It gives an investor an idea of how high a price he has to pay for a share that generates one dollar of earnings per year.
A lower P/E ratio may indicate that a stock is undervalued, as the market is placing a lower value on the company's earnings. A higher P/E ratio may indicate that a stock is overvalued, as the market is placing a higher value on the company's earnings.
The P/E ratio is most often used by comparing different companies operating in the same industry with each other. This allows the investor to draw a conclusion about which company is currently more undervalued in relation to the profit it generates.
An example of using the Price to Earnings Ratio (P/E Ratio) to evaluate a company's stock is as follows:
Let’s consider two companies: Coca-Cola and PepsiCo.
Coca-Cola's stock price is currently at $54, and the earnings per share generated in recent months is $1.8. This gives a P/E ratio of 30 ($54 divided by $1.8). To put it another way, in order to be entitled to one dollar of profit generated by that share, you must first pay $30 for it.
In the case of PepsiCo, on the other hand, the situation is as follows: the share price is $145 and EPS is $5.1. This gives a P/E ratio of 28.
This means that at this point Coca-Cola's stock is slightly more expensive than PepsiCo's, because for one dollar of annual profit generated by Coca-Cola the investor has to pay $30 in share price, while in the case of PepsiCo it is only $28.
Such information is insanely important from an investor's point of view, because it allows to exclude the influence of the mere trading price of the shares in question on the opinion as to whether they are expensive or not.
Seemingly, it is PepsiCo's stock that appears more expensive, since at first glance its price is $145 relative to that of a competitor's stock located at $54.
However, the conclusion will change dramatically if we compare how many dollars of profit we receive in exchange for buying shares of one and the other company.
This type of comparison is possible because here we are relating two values expressed using the same unit, the US dollar, to each other. First, an investor must pay X dollars to purchase a share, which will then generate X dollars for him in the form of profits.