When deciding whether to invest in a company, potential investors generally want to know how much money a company is currently making in addition to its future earnings. The price-to-earnings ratio of a stock is a valuation ratio of a company's current share price compared to its per share earnings. Earnings per share is a measure of how a company is performing financially. This information is included in the calculation of the price-earnings ratio, which is an indicator of the current demand for a company’s stock.
1. Determine a company’s current market price of a single share of stock. Fair market value of stock is the price a willing buyer would pay a willing seller for a share of the company’s stock. Generally, the value of publicly traded stock is the average of the high and low selling prices of the stock on that particular day. Prices are published online and in newspapers.
2. Take a look at the company’s four most recent earnings reports. Companies update earnings per share quarterly. Calculate the company’s annual earnings per share by dividing the company's net income by the number of the company’s outstanding shares. If a company’s stock is publicly traded, earnings per share appear on the income statement.
3. Calculate the price-earnings ratio by dividing the market value per share by the company’s profit, or after-tax earnings per share. This shows you how much investors are willing to pay for every dollar of earnings. For example, if a company’s stock trades at $20 per share and the EPS for the last 12 months is $4, then the stock has a P/E ratio of 5. When calculating the P/E ratio, use the most recent earnings number available to you.
- Current market supply and demand determines share prices in a publicly traded company. Investors consider current market trends, a company’s past performance, future growth potential and the level of anticipated risk.
- The calculation of earnings per share shows investors how much money they would receive for each share of stock they own in a company if the company distributed all of its net profits for that specific accounting period.
- Stock is more expensive for companies with high P/E ratios as investors are willing to pay more per share.
- Although a company with a high P/E ratio is usually considered a riskier investment, it can still be a profitable one. A new, rapidly growing company offers more future growth potential and therefore can have a higher P/E ratio. In this case, investors often are willing to pay more for the a company's stock.
- The estimated earnings of some well-established companies are pretty much a certainty, which makes them less of a risk despite a high P/E ratio.
Items you will need
- Market value of stock
- Company income statement
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