Among the most common and reliable tools many investors use to decide where to invest their money is the price to earnings ratio (P/E ratio), also commonly referred to as the price multiple, earnings multiple, or simply, multiple. P/E ratios are commonly listed in newspapers and on websites that post stock quotes.

In mathematical terms, the P/E ratio equals the company’s market value per share divided by its earnings per share (EPS). For example, if a stock costs $25.00 per share and earns $1.25 per share, its P/E ratio is 20 ($25.00/$1.25 = 20).

Breaking that formula down further:

Price (market value) is the cost of buying one share of the company’s common stock. The price is set by investors based on such factors as their expectations for the company’s future growth, the state of the industry it belongs to, inflation and the overall market. Actions the company takes, such as entering a merger, closing factories or installing a new management team, can have a positive or negative effect on price, depending on how such actions are perceived by the market.

EPS refers to how much one share of stock has earned over a set period of time – commonly the past 12 months – although analysts will sometimes base EPS on estimates of projected earnings, since past performance is not necessarily a sound predictor of future performance. Put another way, EPS is the portion of a company’s overall profit allocated to each outstanding share of common stock. EPS is calculated as the company’s net income (after interest, taxes and other costs are deducted), minus dividends paid on preferred stock shares, divided by the average number of shares outstanding.

What P/E Ratio Measures

The P/E ratio measures the level of confidence investors have in a company. Investors are often willing to pay more for stocks with a high P/E ratio because they expect the company to have high future returns or they believe the company is growing faster than average. However, a high P/E ratio is sometimes interpreted to mean that the stock is overpriced.

At the other extreme, a low P/E ratio might be interpreted as either the market giving the company a vote of no confidence or, alternatively, that the company is undervalued and therefore a good bargain.

In other words, there is no strict rule of thumb when it comes to interpreting the exact relationship between a P/E ratio and the company’s true value as an investment.

One thing most experts do agree on, however, is that it’s usually more useful to compare a company’s P/E ratio to those of other companies within the same industry, rather than compared to the market in general or against the company’s own historical ratio. For example, comparing the P/E ratio of a technology company (typically high P/E) to a utility company (low P/E) doesn’t make sense, because the two industries have very different growth prospects.

Thus, P/E ratios are one effective tool for making apples-to-apples comparisons of similar companies whose stock prices happen to vary greatly.