The price to earnings (P/E) ratio compares the share price of a company to the earnings it generates per share. The formula used to calculate this ratio simply divides the market value per share by the earnings per share (EPS). The typical calculation of the P/E ratio uses a company’s EPS from the last four quarters. A variation on this calculation is known as the forward P/E. Investors or analysts may use projected earnings per share, meaning, the earnings expected to be generated, per share, over the next 12 months. This variation is sometimes known as the leading or projected P/E. The significant difference is that the forward P/E is based on analyst speculation rather than historical data. The forward P/E is an equity valuation metric measuring a company’s P/E using projected future earnings.
The theory behind a stock’s P/E ratio is that it provides an idea of the amount an investor is likely willing to pay per dollar generated in earnings. The P/E ratio also accounts for company growth expectations in the market. Because stock price is a reflection of what investors determine a company is worth, the value accounts for growth. The P/E ratio should be considered more in terms of the optimism of the market for a company’s prospective growth. A company that has a higher P/E ratio than the industry or market average indicates an expectation that the company is likely to experience a significant amount of growth. If a company’s stock fails to meet the high ratio value with increased per share earnings, the price of the stock will fall.
Ultimately, the P/E ratio is a metric that allows investors to determine how valuable a stock is, more so than market price alone. The P/E ratio is particularly helpful for comparing similar companies within the same industry.