What is the significance of a price earnings ratio?

A price earnings or PE ratio is calculated by dividing a company’s earnings per share by its share price. This ratio, also called a PE multiple, is one way to gauge whether a stock is cheap or expensive compared to its own trading history, other stocks in the same industry or the market as a whole.

For example, if a company has traded at an average of 12 times earnings for the past 5 years, and it is trading today at 10 times earnings, while other companies in the same industry are trading at 14 times earnings, it might be considered undervalued.

When comparing PE ratios, it’s important to know what earnings are being used in the calculation. Some analysts use net earnings, some use operating earnings. Some use earnings for the trailing 12 months, others use expected earnings for the next 12 months. Make sure you use consistent earnings numbers when comparing one company’s PE against another’s.