P/E Multiple stands for Price / Earnings multiple and is one of the most frequently used measure to value a share price.
Here price stands for the current market price at which the stock is trading. Earnings stand for EPS (Earnings per share) and normally the annual profits for the last financial year are considered while calculating EPS.
For arriving at the P/E Multiple you need to divide the Current market price by the EPS of the company. So if the stock is trading currently at $100 and the EPS is $10 then the P/E multiple is 10.
A rule of thumb is that high growth stocks would trade at a higher P/E multiple and that is why investors would observe that the P/E multiple for Google would generally be higher than the P/E multiple of Walmart, even though both are excellent companies in their own right.
P/E Multiple can really help investors to determine whether the price that an investor is paying for a stock is high or low. Usually investors just consider the price and say, well Apple trades at $170 and Google at $544 so Google is more expensive. What they completely ignore is that Apple is making $4.85 per share or the EPS of Apple is $4.85 so its P/E Multiple is 35 whereas the EPS for Google is $14.23 so its P/E Multiple becomes 38 and therefore both companies are priced more or less equally by the market.
P/E Multiple is a good measure to determine whether to buy a stock when you have already done your research about the fundamentals of the company and are confident that the company in itself has sound operations and that buying it would be a good idea.
This is like saying that you have done your research among various car manufacturers and are confident that buying a Honda or Toyota would be a good deal.
The next step is to compare the prices of the car. However in case of stocks you cannot do a stock price comparison because of the difference in EPS between various companies. If you were to compare Google to Apple strictly based on the stock prices you would be misled as we just saw in the example above. Therefore a good way to compare what is being offered by the market is to take the P/E multiples and see how much you are paying for the stock.
It is usually best to compare stocks within the same sector because different sectors trade at different range of multiples. For example technology stocks normally command a higher P/E than utility stocks because of the higher earnings growth potential.
So the key factors to be kept in mind while using P/E ratio is to do your fundamentals research first and then to use it on companies narrowed down on the same sector.
