The price-to-earnings ratio helps investors to save time by not wasting time researching a stock that is likely to be too expensive or too cheap for their risk tolerance. Many investors have a limit on how much they are willing to spend on an investment, in relation to its earnings.
The P/E ratio is calculated by dividing the market capitalization of a company by its earnings. For instance, a company with a market cap of $1m and earnings of $200k, would have a P/E ratio of 5.
The standard price-to-earnings ratio is 20, meaning that investors typically accept paying 20 times the earnings of the company. So if a company makes a $1 profit, then an investor would be willing to invest at a price of $20.
With that in mind, an acceptable price-to-earnings ratio tends to vary from one industry to another. Investors are usually more willing to invest at a higher ratio in industries, like technology, while preferring to accept a low ratio in other industries, like banking. For instance, Tesla currently has a price-to-earnings ratio of 202 (as of April 2022), while J.P. Morgan has a ratio of just 8.5 (as of April 2022).
These differences allow investors to easily compare different investment opportunities within the same industry. If one company has a higher price-to-earnings ratio than the average, it could be a positive sign.