The Price-to-Earnings Ratio Explained

Paul Vorstadt is a financial professional based in Toronto, Canada. As graduate of Wilfrid Laurier University with a B.A. in economics, Paul Vorstadt is a Certified Financial Planner and Fellow of the Canadian Securities Institute. As such, Mr. Vorstadt knows that a strong understanding of the price-to-earnings (P/E) ratio helps investors make sound financial decisions.

The P/E ratio is calculated by dividing the current market value of a stock by earnings per share for the previous year. For example, if the current market price of a stock was $43 per share, and earnings per share for the previous year was $1.95, the P/E ratio would be 22.05.

The general rule of thumb is, a higher P/E ratio means higher earnings growth is expected over competitors with a lower P/E ratio. The ratio does not tell the entire story, however. The P/E ratio is a relative metric. In order for it to have any meaning, it must be compared against industry or market averages. Once the P/E ratio of an industry is understood, it can then be used in the identification of attractive investment opportunities.

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