P/E: The Price to Earnings Ratio | What is it really?

P/E is the ratio of the market price to the earnings per share. It can also be calculated as the ratio of the market capitalization and the net profit. The P/E ratio shows the relation between the market price of a share of a company and the financial performance of the company in terms of net profit.

Why is it significant?

The P/E is an important parameter to fundamentally analyze any stock. Since the P/E shows the relationship between the pricing of a share and the net profit, it indicates how expensive a stock is in the market, as against how well it is performing financially. A low P/E (say, less than 15) means that the stock is not expensive at the moment and a high P/E (greater than 15) means that the stock is expensive, vis-à-vis its earnings per share.

The earning per share is an important measure which indicates the part of the (net) profit each share is notionally entitled to. The P/E therefore is indicative of the extent to which you will have to pay to get the share of the earnings you will notionally entitled once you have bought the share. Buying a high P/E stock means that you will be paying more to get, in return, a stock which gives you very less earnings per share in comparison to the amount you paid per share.

Many people do know this, and therefore they pay attention to the P/E of a stock. They feel tempted to buy a low P/E stock and avoid high P/E stocks. This reasoning is true only to mathematics minus probabilities. Real fund managers and investors look for growth in the EPS. A good EPS is fine. But a growing EPS is better.