Q:

How does the P/E ratio work?

A:

The earnings to price, or P/E ratio, is calculated by dividing a company's stock price by its earnings per share, notes About.com. The earnings per share, or EPS, is calculated by dividing the number of outstanding shares of a company into its net revenues.

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The P/E ratio is an indication of how much people are willing to pay for a company's earnings, with a higher P/E an indication that people are willing to pay more, states About.com. A high P/E ratio may mean that people have confidence in the company's future, though it may also signal that stock in the company is overpriced. A low P/E ratio could mean that investors have overlooked the potential of a company, or it may signal that they have no confidence in the company's future. Investors interpret P/E ratios based on their willingness to see value in specific companies, and there may be disagreement as to how to interpret those ratios.

People can derive the earnings per share used to calculate the P/E ratio in three ways, including using a company's numbers from a previous year, according to About.com. They can also calculate the earnings per share using current company financial data, though this calculation would be at least partially a projection. Forward earnings per share are based completely on a company's future projections.

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