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Financial Markets: What Is The Price To Earnings Ratio?

For those without experience, the stock market can seem like a complicated entity.  But the reality is that most of the strategic conclusions that are drawn by hedge funds and other large investors can be boiled down to relatively simple math equations.

One example is the price-to-earnings ratio, or P/E ratio.  This financial metric is often used to assess a stock’s market price level in relation to its ability to generate corporate earnings over a specified period of time.  The P/E ratio can be useful in determining whether a stock is “cheap” or “expensive” when compared to the rest of the market.

P/E Ratio: Understanding the Calculations

The first step in understanding the P/E ratio (and its applications) is to look at the equation itself.  Here, we can see that we can arrive at the P/E ratio by dividing the current share price by the company’s earnings per-share.

To clarify, a company’s earnings per-share uses numbers reported each financial quarter (3 months).  This gives us an understanding of the financial health of the company, and net income figures for the year are tabulated by combining earnings from the prior four quarters.  

The earnings per-share calculation then requires us to divide net income for the year by the total number of shares outstanding in the market.  This is an important market term that is commonly used when discussing finance and when studying more advanced concepts in economics.

For example, Apple Inc. (NASDQAQ:AAPL) is currently trading at a share price of $183.83.  According to Apple’s earnings reports, the company is showing earnings of $9.73 in the trailing twelve month (TTM) period:  183.83/9.73 = 18.8.

This means we can say that APPL is currently trading at a trailing P/E ratio of 18.8.  It is then possible to compare Apple’s P/E ratio to that of other companies in the same industry.  This is important because it is one way of determining which companies are trading at low valuations within the industry.  

We should remember that a stock’s P/E ratio is constantly changing.  The current number will always depend on the price of the stock and on the results of upcoming earnings report released by the company.

Theory in Practice: What is the Impact of Interest Rates?

More broadly, P/E ratios are important when understanding the market as a whole.  Classical economics tells us that rising inflation tends to be associated with rising interest rates at the Federal Reserve.  

Higher interest rates mean more expensive credit costs, and this can weigh on consumer spending. In the chart below, we can see some of the ways market P/E valuations can be impacted by rising interest rates:

Interestingly, many of the market’s most famous stock crashes have come during times of rising interest rates at the Federal Reserve.  This type of event has been seen in 1929, 1966, and after the tech bubble in 2000.

The P/E ratio gives us additional information about the earnings strength of a company (when compared to simple prices by themselves). This makes the P/E ratio a valuable statistic when making investment decisions or when making academic assessments about the economy.  

The financial markets can seem complex at first glance.  But many of the most basic economic ideas are actually simple math equations that can be completed by anyone.  The P/E ratio is a good example of this, as it can offer an alternate way of looking at the economy or at the strength of a company’s performance.  If we want to know which companies are cheap compared to the rest of their respective industries, the P/E ratio is one of the best ways of making that determination.