Understanding the EPS and P/E Ratio
Understanding the EPS and P/E Ratio
To truly comprehend how the stock market works, any good investor must first get acquainted with the important stock market concepts of EPS and P/E ratio. The EPS and P/E ratio are not only stock market concepts; they are also used in fundamental analysis of the stocks and serves as a good economic indicator of the corporation.
As you may have already known, the EPS or Earnings Per Share represent the profit of the company as divided into each of the owners, otherwise known as the shareholders of the corporation. For example, if corporation ABC has 10 million shares of stock that is being publicly traded and has a net profit of $12 million, the EPS of the corporation would be computed by dividing the profit, which is $12 million, and the number of shares of stock of corporation ABC yielding an EPS of $1.2. If person X owns 20 shares of corporation ABC he would get a total profit of $24. EPS is a good economic indicator of the different corporations as all corporations have them, giving a good standard for the investor in examining the stability and profitability of the corporation. As a general rule, the higher is the EPS of the corporation is better. It is also good to invest in a corporation that has a continuously increasing EPS.
The P/E ratio or the Price-to-Earnings ratio, on the other hand, is a comparison of the stock price and the EPS of the corporation. It shows how much the investor is willing to pay for to get the profits per share of the company. The P/E ratio is computed by dividing the price of the stock and the EPS. In our earlier example, let us assume that the stock price of stock ABC from corporation ABC is $10 per share. To compute the P/E ratio you divide the $10 stock price and the EPS of $1.2 getting a P/E ratio of 8.33. This means that investors of ABC company are willing to pay $8.33 to get a $1 earning of the stock. The P/E ratio is also a good indicator of how expensive your stock is. You can do this by comparing the P/E ratio of your company and the P/E ratio of similar companies in the same industry. In the same way, you can also compare the P/E ratio to the market P/E ratio, which is the P/E ratio of the top 500 corporations in the stock market.
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