A price-to-earnings (P/E) ratio is a current stock price divided by annual earnings per share (EPS). All three components in the equation -- stock price, earnings per share and resultant P/E -- are constantly changing. A change in one component causes changes in the other two.
EPS are relatively constant: They change from quarter to quarter or whenever a company issues more of or buys back its stock; however, a stock's price and P/E can change with every trade. A rising stock price results in a higher P/E, while a falling stock price results in a lower P/E. A change in EPS will change the P/E and could lead to a change in the stock price, which, in turn, would further affect the P/E.
A P/E shows how much investors are willing to pay for a dollar of earnings. The higher the EPS growth rate, the more investors are willing to pay for a stock and the higher its P/E can get. For example, XYZ, with an EPS growth rate of 10 percent, may have a P/E of only 8 because investors see poor growth prospects; ABC, with an EPS growth rate of 30 percent, may have a P/E of 40, or even 60. A stock price and its P/E, will generally increase or decrease in proportion to the EPS growth changes.
Although different stocks and stock groups have different P/Es based on their respective growth rates and prospects, P/Es are not permanent and can expand or contract with the economic cycle, market conditions or investor outlook. In other words, how much investors are willing to pay for the same dollar of earnings in a stock varies. For example, ABC, with an EPS growth rate of 30, may command a P/E of 30, 40, 50 and 60 as the stock advances in a strong market, and decline to 50, 40, 30 and even 20 in a weak one, without much change in the EPS growth rate. The dramatic change in the P/E would be caused by changes in the stock price.
When a stock's price declines, its P/E shrinks. Value investors may then believe the stock to be cheap and start buying it, which pushes the stock's price and P/E back up. The higher the stock price goes, the higher its P/E becomes. When some investors think that a stock's P/E is too high, they consider the stock too expensive and start selling it, so its P/E shrinks. The lower the P/E goes, the more value buyers the stock attracts, and their buying checks the decline and starts pushing the stock's price back up.
- "PassTrak Series 7: General Securities Representative License Exam"; Dearborn Financial Services; 2003
- "One Up on Wall Street"; Peter Lynch; 2000
- "Jim Cramer's Real Money: Sane Investing in an Insane World"; By James J. Cramer; 2009
- Jupiterimages/Polka Dot/Getty Images