If you are a new business owner or are just thinking of starting your own business, you must first learn the vocabulary of the business world.And along with the many terms involved in running a business, you must also learn the terms of finance and economics.
At some point during your time as a business owner, you may want to consider making your company stocks available to your employees.Or perhaps you want to make your stocks public and allow other people to invest in your company.Regardless what you decide to do with your company and its stocks, there are certain terms that you must be familiar with before you can make an educated decision.A term included in this is “price/earnings ratio,” also known as P/E ratio.

So what is a price/earnings ratio?What does it mean and how does it affect your business?Hopefully, after reading this brief article you will at least have a general idea of the answers to these questions.

Price/earnings ratio refers to the world of stocks.It is also called “earnings multiple” or simply “multiple” (the price/earnings ratio is sometimes called the “multiple” because it describes how much investors are willing to pay per dollar of earnings.)It is used to measure how cheap or expensive a share of a company is.If your price/earnings ratio is low, you have to pay less for the stock.Of course, a lower priced stock will also yield a smaller profit.But a more expensive stock will usually yield a higher profit.

Let’s look at price/earnings ratio in more mathematical terms.

P/E = Price per share
Earnings per share

The top number (or numerator, if you can remember back to grade school math) is the price per share, meaning the market price of one single share of a stock.The bottom number (or denominator) is the earnings per share, which is the net income (net income is the total money taken after all costs-e.g. taxes and bills) of the company for a given period of time (usually the most recent 12 months, or some other division of a time).Earnings per share are calculated by dividing a company’s profit by the “weighted average common shares” or the net income-preferred dividends by “weighted average common shares.”

Let’s try to calculate an example.You company is company X.You are trading your stocks at $32 a share and your earnings per share for the past 12 months is $4.

P/E = 32
4

So your price/earnings ratio is $8 for every one dollar of earnings.

Why would you want to know your P/E?One reason is that investors use this number to compare the value of stocks from different companies.If company Y had a price/earnings ratio of $16 for every dollar of earnings, an investor might say that your company, company X, is probably a less attractive investment.However, beware of making too many comparisons between different types of companies, especially between different countries and throughout a lengthy time period.You should only compare between similar types of stocks.Meaning that you should only compare between similar companies.

There is also a difference between fundamental price/earnings ratio and the actual way it’s computed.The fundamental P/E looks at the earning potential of your stock.If your company stock is trading at a low P/E, that does not mean that your stock is undervalued.It may be simply because investors are wary about the future earning of your stock.In reality your stock may be doing much better than predicted.But in general, a high P/E suggests that investors are predicting your stock to grow.

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