Before you buy and sell on the stock market, it pays to know some tricks for measuring risk. One way to do this is the price-to-earnings ratio. You’re bound to read and hear a lot about P/E ratio as you get involved in the world of trading, and while you may grasp what it is relatively quickly, chances are it’s going to take some time to understand what it means to you, the investor.
So, before the numbers start flying fast and furiously, let’s take a moment to break down just what the P/E ratio is, and we’ll put its usefulness in a context that should be helpful when making buying-and-selling choices.
What is P/E?
Price-to-earnings is a measure of how much, in general, investors are willing to pay for the earnings generated by a share of stock. The higher the number, the more investors in the market are willing to spend.
For example: if Apple is selling stock at about $390 per share (as it was in December 2011) and its earnings per share is about $28, then its price-to-earning ration is found by dividing the price by the earnings.
Apple’s P/E would be $14. What this tells us about Apple stock is that investors are willing to spend $14 for every $1 of earnings (as measured at the time it’s purchased).
Wait a minute. Spend $14 for $1 of earnings? Can that be right?
It may seem initially counter-intuitive to spend fourteen dollars to make one dollar, but the operative phrase is “at the time it’s purchased.” Remember that time is an important factor in this equation. Investors bet on the future, spending money on Monday with hopes of making it back, plus profit, on Friday. And maybe the Friday in question is years away, but the idea is still intact.
To put P/E another way, it is a measure of how much short-term expense the investor is willing to accept, with the idea that longer-term profit will more than compensate for what they paid out in the first place.