Price to Earnings ratio, P/E ratio, PER

The P/E ratio is simply the price of the stock divided by its earnings per share. It is the most widely used yardstick to value a stock (i.e. to see if the stock is cheap or expensive). In short, P/E is the same as trying to determine the value of a product by dividing its price by its quality. Here the quality of the company is determined by how much money it makes. To give an analogy, Car A and Car B sells for $10,000 and $20,000 respectively, A saves $200 of petrol per year while B saves $500 of petrol per year after driving the same distance. Which is a cheaper car? Answer: Car B, because the Price / Petrol Savings is lower for B ($20,000/$500 = 40) than A ($10,000/$200 = 50). Similarly, a stock with a lower P/E ratio is cheaper stock, because for a certain price, you are getting better quality (i.e. the company generates more earnings). Historically, P/E for major markets have fluctuated from 10 to 40. (40 during the IT bubble). P/E ratios of individual stocks can be as low as 2 or 3. This simple but effective rule has been proven to make money over the long run.

The P/E ratio might be the single most important no. in investment as it gives an investor a quick and fairly accurate sense of how much a company is worth. Over the years, analysts and academics developed other valuation metrics like EV/EBITDA, EVA (with a copyright) PEG ratio etc, but nothing beats the simplicity of P/E. Surprisingly, most retail investors probably never heard about this when they buy their first stock and mainstream business news fail to mention this important ratio most of the time.