P/E ratio stands for price/earnings ratio, which basically aims to calculate the valuation of a given company. The ratio is calculated by simply dividing the stock price by the company’s earnings per share.
In layman's terms, the P/E ratio shows how much investors will pay per share for each $1 that company generates in earnings.
There are two types of P/E ratios. The first is called a trailing P/E ratio and is the most common type as it is based on the earlier quarters. For instance, the trailing P/E ratio is calculated by dividing the stock price by the company’s earnings per share in the past four quarters, or 12 months.
On the other hand, the forward P/E ratio is based on the projected earnings of quarters that are ahead of us.
A high P/E ratio tends to imply that shares of the company are too expensive or overvalued. In this case, investors are paying too much for shares given how much earnings the company is able to generate. A high P/E ratio is common for high-growth tech stocks that use a lot of capital to invest in their business and make it more sustainable.
Conversely, a low P/E ratio is typically associated with older, more stable companies that are attracting value investors.
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