The price earnings multiple compares the earnings per share reported by a company to the market price of its common stock. This multiple is used by investors to judge how expensive a share of the company’s stock is. During a declining market, the overall price earnings multiples tend to decline for the shares of all companies, with the reverse occurring when the economy is expanding.
Investors tend to bid up share prices, which increases the price earnings multiple, when there is an expectation of greater earnings in the future, even if the issuing entity is not currently reporting increased earnings per share. This can occur when a promising new product or service is released or announced. The multiple may also increase when the reported earnings per share exceed the expectations of analysts.
The Price Earnings Ratio or P/E ratio is a ratio for valuing a company that measures its current share price relative to its per-share earnings.
The price-earnings ratio can be calculated as:
Market Value per Share / Earnings per Share
Conversely, the multiple is more likely to decline under any of the following circumstances:
- A business reports disappointing earnings
- A competitor releases a product that will directly compete with the company’s products
- Trade barriers with another country are removed, increasing the risk of price competition
- A lawsuit with a potentially large payout is filed against the company
In all of the examples, there is an indication that future earnings per share will decline.