Question

What determines the price of a share of stock? Discuss what the P/E ratio is and the importance of the PE ratio. Choose a company and explain what the P/E ratio of that company means.

Answer 1

Just like any other product, the prices of a share of stock are determined by the demand and supply of the stock. The Supply of the shares is limited in broader terms, however, the existing holders of shares keeping selling their shares and new buyers keep coming in. For each buyer and seller, they give a price at which they want to sell. And, one two buy/ sell prices match, the transaction happens.

Therefore, the prices quoted in the market and transacted upon determines the price of the stock. However, to make the buying and selling happen, there are various factors such as growth prospects, current performance, industry overview, economic scenarios etc. which affects the share.

What is P/E Ratio

P/E ratio, on the basis of the formula, means how many times the market price of a share is of the current earnings of the stock. In the simple words, we can say that how much a buyer is willing to pay for every $1 that the company earns.

For example, Facebook Inc. has a P/E of 23.94, that means that to earn every $1 in the company, the buyer is willing to pay $23.94 of the price.

Importance of P/E Ratio

The P/E ratio helps the investor to determine whether a stock is overpriced or underpriced. Generally, an investor compares the financial results of various competitor companies and the industry as a whole. P/E ratio helps the investor to determine which of the companies in the Industry is overpriced and underpriced. This also helps the investor to determine what's the market overview of a specific Industry or a specific company.

For example: If the average P/E of the Industry is 12.45, in that case, Facebook would be an overpriced company. However, it is not always binary like that, high P/E might also mean that the company has some breakthrough technology or growth potential.