The two biggest measures or financial ratios that are used, based on corporate earnings, that determine stock prices are earnings per share (EPS) and the price-earnings ratio (PE). What is the difference between the two?

Question

What will be an ideal response?

Answer 1

Earnings per share (EPS) is a simple measurement that looks at total after-tax earnings and divides it by the number of common shares outstanding. For example, if a company earns $5,000,000 after taxes and there are one million shares outstanding then their earnings per share are $5,000,000 / 1,000,000 = $5 per share. Many investors are looking for stocks to have increasing earnings per share from year to year or from the same quarter of one year to the same quarter of the next year. The price-earnings ratio (PE ratio) is simply the price of the stock (as listed on the stock exchange) divided by the earnings per share. In this example, assume the current price of the stock was $20 per share. Given the EPS of $5 we calculated, the PE ratio would be $20 / $5 = 4. So what does that number mean? Basically, for every one dollar of earnings, investors are willing to pay $4. That is because they are assuming the earnings will continue in the future. A PE ratio of 4 is low as an overall average, but it depends on the industry. PE ratios are usually compared to other similar firms and their PE ratio. According to some investors, if a company has a higher than average PE ratio, then the stock may be a bargain because investors have not yet valued the future earnings of the company as much as other similar companies. On the other hand if the PE ratio is low, then the stock may be overpriced because investors are valuing the future dollars of that particular company more than the dollars of similar companies. Another theory is that since the markets are efficient the PE ratio is exactly where it should be and there may be other reasons, such as uncertainty and risk from one company to the next that could explain the difference in various PE ratios.