Description
The most commonly referred to measure of relative valuation is the Price to Earnings ratio. In a nutshell, this number compares the price per share of a stock to the amount of earnings per share (note that earnings per share is the same as net income per share).
Calculation
What it Means
How much is too much to pay for a stock? Is company A’s stock selling for $100 dollars a share more expensive than company B’s stock selling for $10 a share? At first glance, it seems that logically the $100 stock is more expensive. However, it actually depends on how expensive the stock is when compared to its Earnings Per Share (EPS).
For example, if company A has an EPS of $50, then its P/E ratio is $100 / $50 = 2.0. That is, it trades at a price which is two times EPS. Now, if company B has an EPS of $1, then its P/E is $10 / $1 = 10.0. In this case, the $10 stock is actually more expensive because it trades at 10 times EPS vs. 2 times EPS.