Often in brokerage reports and stock recommendations we come across statements such as this X stock trades at say 9.5 times its FY23 estimated earnings. And by saying so the analyst compares the stock's market price with the company's profitability. Herein the P/E ratio or price/earnings ratio also called as earnings multiple comes into picture. This is the most commonly used ratio basis which the stock's future prospect is judged or is the ratio that helps in determining the value of the company.
So, if the P/E is 5 times, this can also be said as that the stock trades at a multiple of 5 times its earnings.
P/E or price to earnings is computed as though:
Market price of a stock divided by the company's earnings per share
Hence a stock that trades at 20 times earnings with a P/E ratio of 20 is the stock quoting at Rs. 40 per share and divided by its earnings per share of Rs. 2.
Now here is a simple interpretation of the same i.e. what does this simple statement mean that the stock trades at 20 times its earnings from an investor's point that for the investor share of the profit for each unit of the common stock held by him or her shall be equal to 1/20th of the stock's price. And this can also be obtained as an yield by simply calculating the inverse of the earnings multiple or price to earnings ratio and so herein it shall be 1/20 or 0.05 and then multiplying by 100 we get percentage yield of 5 percent.
Further if the P/E also known as price multiple stands high it is either highly valued or may be analyst or investors expect high growth from the stock over time. Also, more often the high P/E is associated with high growth prospects.
There are also instances where the company has no P/E as in the case when there are no earnings.
So, this valuation parameter helps understand whether the stock is overvalued or undervalued and also can help understand how the stock compares within its industry or to the benchmark.