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The price-to-earnings ratio, or P/E ratio, helps you compare the price of a company's stock to the earnings the company generates. This comparison helps you understand whether markets are overvaluing or undervaluing a stock.

The P/E ratio is a key tool to help you compare the valuations of individual stocks or entire stock indexes, such as the S&P 500. In this article, we'll explore the P/E ratio in depth, learn how to calculate a P/E ratio, and understand how it can help you make sound investment decisions.

What Is the P/E Ratio?

The P/E ratio is derived by dividing the price of a stock by the stock's earnings. Think of it this way: The market price of a stock tells you how much people are willing to pay to own the shares, but the P/E ratio tells you whether the price accurately reflects the company's earnings potential, or it's value over time.

If a company's stock is trading at $100 per share, for example, and the company generates $4 per share in annual earnings, the P/E ratio of the company's stock would be 25 (100 / 4). To put it another way, given the company's current earnings, it would take 25 years of accumulated earnings to equal the cost of the investment.

Generally speaking, a low PE ratio indicates that a stock is cheap, while a high ratio suggests that a stock is expensive.

However, the PE ratio can also indicate how much investors expect earnings to grow in the future. The higher the ratio, the better the growth prospects.

A simple way to think about the PE ratio is how much you are paying for one dollar of earnings per year. A ratio of 10 indicates that you are willing to pay $10 for $1 of earnings. It effectively gives you an "earnings yield" of 10%.

If earnings remain constant, a PE ratio of 10 means it will take ten years to earn back your initial investment.

The PE ratio is commonly used to value individual stocks, or even entire markets or industries. You can also use it to compare two or more stocks or markets against one another.

Key Takeaways:

1. The price-to-earnings (P/E) ratio relates a company's share price to its earnings per share.

2. A high P/E ratio could mean that a company's stock is overvalued, or else that investors are expecting high growth rates in the future.

3. Companies that have no earnings or that are losing money do not have a P/E ratio because there is nothing to put in the denominator.