The Price to Earnings (PE) ratio is calculated by dividing the share price by the earnings per share value. This is one of the most important ratios you need to determine for any investment you make.

A very high PE ratio implies that the market is expecting high growth from the company but it also implies that the shares may have been chased high and now be overvalued. You need to exercise caution when purchasing shares which are trading significantly above their average PE or indeed above their industry’s average PE – any setbacks in the performance of the company will cause the share price to collapse.

Similarly a very low PE indicates that the market is not expecting very much growth from the company at all and has priced it as such. Low PE stocks can be considered to be bargain stocks but only if the company is expected to turnaround at some point – again caution is advised when considering ultra low PE stocks.

Companies trading at PE ratios slightly below their average may be temporarily oversold and hence may be considered to be good value since they will exhibit capital gain once the PE ratio moves back to average assuming that earnings do not fall.

 

(image attribution: Wall Street NYSE by Ken Lund from flickr)