P/E Ratio

The P/E ratio (Price-to-Earnings ratio) compares a company's stock price to its earnings per share. For example, if a stock costs $100 and the company earns $5 per share each year, its P/E ratio is 20 — meaning investors are paying $20 for every $1 of yearly profit.

A high P/E often means investors expect strong future growth. A low P/E can mean a stock is undervalued — or it can mean investors are worried about the company's future. P/E ratios are most useful when comparing similar companies in the same industry, since "normal" varies a lot by sector.

Here's a way to picture it. Imagine two made-up companies whose shares both cost $50. Company A earns $5 per share, so its P/E is 10. Company B earns $1 per share, so its P/E is 50. The share prices are identical, but investors are paying five times as much for each dollar of Company B's profit — usually because they expect Company B's profits to grow much faster.

That's why a share price on its own says nothing about whether a stock is cheap or expensive. The P/E ratio gives you a common yardstick, and a way to ask what expectations are already built into a price.