PE Ratio of a stock is calculated by dividing price of a stock on a particular day by usually its latest EPS. (Annual)

Thus it a very fair method of valuating stocks. What I mean is say a stock is quoting at 30 and its latest Earning (per share) is 3, this implies that the current PE is 30/3 = 10. That is the stock is trading at a multiple of 10 to its 1 years earning.

Usually this yardstick is used to analyze whether a stock is undervalued, overvalued or trading at fair value.

As an example we may say that a stock may be considered overvalued if it is trading at a PE of 50, undervalued if it is trading at a PE multiple of 5 and fairly valued if it is trading at a PE of 10. (Just to give you an idea).

But this valuation is market driven and in most of the cases you may stand to gain by buying low PE stocks and selling high PE stocks.

But again, for a blue chip a PE of even say 20 may be undervalued and for a new company or un professionally managed company a PE of even say 6 may be overvalued.

You will be taught this in more detail in upcoming topics. Want to Discuss more about PE Ratio?