The Price to Earnings ratio (P/E ratio) is one of many ratios used by investors to evaluate how expensive or cheap a stock is relative to its historical cost. To determine whether a stock is relatively cheap, the P/E ratio for the specific stock is compared to the P/E of the company’s competitors and also to the industry average. A typical rule of thumb is a P/E ratio of 10 or less implies that the stock is cheap; however there are several caveats to this rule. Historical P/E ratios are often industry specific and some industries have low P/E ratios, while others have higher P/E ratios. Companies in rapidly growing industries tend to have higher P/E ratios than companies in established and lower margin industries. A company can also artificially manipulate the P/E ratio by re-purchasing its stock, thereby increasing its earnings per share which has the effect of reducing its P/E ratio. Even with all of these caveats, the P/E ratio is a useful tool amongst many tools used by investors to assess the value of a specific stock.

The P/E ratio is a very simple ratio to calculate. If we assume that PepsiCo inc. the distributor of the Pepsi beverage is selling for a price of $68.26 per share and earned $3.47 per share in the most recent 12 month reporting period, then the P/E ratio will be $68.26/$3.47 = 19.67. Next, we can compare PepsiCo’s P/E ratio to that of its closest rival Coca Cola. Assume that Coca Cola is selling for $59 per share and reported earnings per share of $2.66 in the last 12 month reporting period, and then Coca Cola’s P/E ratio will be $59/$2.66 = 22.18. Everything being equal, we will conclude that PepsiCo is cheaper than Coca Cola at current prices due to its lower P/E ratio and hence a better buy.

PepsiCo’s lower P/E ratio relative to Coca Cola’s P/E ratio should not be evaluated in isolation; other factors have to be considered, such as the quality of each company’s products, each company’s management, and each company’s historical earnings. Other factors to consider include whether or not the company has recently re-purchased shares, thereby increasing their earnings per share due to a reduction in outstanding shares and whether the company has recently split its stock thereby increasing the total number of outstanding shares. It is important to consider these factors since they impact the calculation of the P/E ratio and hence the interpretation of the ratio.

The calculation of the P/E ratio is also vulnerable to the vagaries of earnings since P/E ratios are calculated based on the historical 12 months earnings data; however, history does not always predict the future. Sometimes, the ratio is calculated based on projected earnings, again, how accurately can future earnings be projected? Also, the P/E ratio cannot be used to evaluate companies that do not have earnings. Various accounting inaccuracies can result in a significantly flawed earnings numbers.

Even with the challenges that exist to accurately determining P/E ratios, the P/E ratio is still one of the most widely used ratios and is a very good tool for assessing the fair price of a stock and for comparing a specific stock to the stocks of other companies in the same industry.