Price Earning Ratio (P/E Ratio) explained in layman's language

Price Earning Ratio is a ratio of price divided by earnings.  Price is the published value of one share.  Earning applies to the earning per share.  P/E value is also available in Google finance or Yahoo finance.  Why is P/E ratio an important ratio? We always look in our past and many a times make decisions based on our past experience. In our mind we have stored past information about these ratios. For different industries and sectors we assign different number for this ratio. For example we do not assign the same number for financial industry as we do for technology industry. We may be comfortable with a price earning ratio of 20 or 30 in technology. In the past these ratios have even reached 100 and 200 as it happened in the year 2000. In financial this kind of ratios will be troubling and we may be comfortable with a ratio of 7 to 15.

Generally speaking we are looking for a lower P/E ratio. What happens if all of a sudden the earnings disappear and becomes zero. If a price is 20 and earning is zero then the ratio will be 20 divided by zero which is an infinite number. In this case should we decide to dump the stock of this company? Not necessarily. We have to look for the other factors before we make such a decision. Price earning ratio is not the only factor we should rely on to make our decisions.

In a troubling economy like the one we have now, price earning ratio for each and every industry and sector has come down. If the economy improves and people feel more confident about the economy then even without earning going up we would be ready to assign a higher number for this ratio as we did in 1999 and 2000. In this case even without earning going up price of the stock will go up.

Now let us look at the financial companies like J P Morgan, Wells Fargo, Bank of America or Citibank which have really suffered in this economy. Assuming that these banks are not nationalized, billions of dollars our government has poured in these companies along with the refinancing boom at a very low interest rate would be a real boom to the earnings of these financial institutions. Banks are on the mend, with the help from low interest rates, fat lending margins, dwindling competition and lending in the financial markets.

As I mentioned previously if all of these factors improve the earning power of these banks, then the P/E will go down and the price of the stock will go up.  Earning could still suffer because of credit card defaults, commercial borrowers default and write down of toxic assets which would require banks to borrow money from the government or private sources.

Please note that P/E is an important factor in your decision but is not the only factor.

Where can you find a P/E ratio? You can go either at www. googlefinance.com or www.finance.yahoo.com and type in the symbol of the company to find a P/E ratio.