Price / Earnings Ratio

Most investors evaluate the “multiple” of a stock based on a figure known as the price to earnings ratio (P/E).  You can think of a P/E ratio as a measure of how much profit a company made for each share of stock.  Think of the P/E ratio of what investors have agreed to pay each other for every dollar of earnings that a share represents.  This only makes sense if we look at the value of a stock in terms of future earnings.  When you pay $10 or $20 for a single dollar’s worth of earnings, you are banking on the fact that this profit will be coming in for many years to come, and that the dollar will grow to several dollars.  When companies grow and become more profitable, the earnings grow, and the P/E ratio shrinks.

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