If you are investing in stock market and you don't know P/E ratio then you are gambling and not investing. So it is very important to understand P/E ratio and apply this concept while investing.

What is P/E ratio?

It is the ratio of Company's current share price to its earning per share. For example, if XYZ Company's share is trading at Rs. 120/- and it EPS for trailing 4 quarters is Rs. 20/- then XYZ stock is trading at P/E = 6. Means, if decide to invest 120/- in XYZ Company today which is trading at P/E 6 then it will take 6 years to gain same amount of money invested.

P/E = Price of stock / Earning per share.

P/E ratio is useful for deciding how the stock is valued. Higher P/E ratio is indication of more expensive stock while lower P/E ratio is indication of cheap stock. One should always take average of last 4 to 6 years EPS instead of last few quarters. This way we can judge Company's earning power in more better way. For example, if EPS of Indian Hotel for year 2004 =5, 2005 =8, 2006 =2, 2007 =3. Avg EPS = (4+7+2+3)/4=4. At current price of 60/-, P/E of Indian Hotel = 15x.