From an accounting standpoint, earnings are calculated by subtracting operating costs, taxes, and preferred stock dividends from revenue. Those earnings are typically divided by common stock shares outstanding to come up with earnings per share, or EPS. EPS is a convenient way to compare earnings over a period of years, so upward or downward trends can be identified.
The price/earnings ratio, or P/E ratio, is calculated by dividing the stock's price by its EPS. It's one of the most common measures of stock value, both for individual stocks and the overall market. It basically indicates how much investors are willing to pay for a dollar of the company's earnings.
For individual companies, investors' expectations regarding future earnings affect the P/E ratio. Confidence that a company will improve its profitability or remain profitable generally results in a higher P/E ratio. If profits are threatened or weak, the P/E ratio is likely to drop. P/E ratios for the overall market change based on broad market conditions and investors' views about how desirable stocks are compared to other investments.
A company's growth prospects can be evaluated using the price/earnings growth, or PEG, ratio, which is calculated by dividing the P/E ratio by the company's projected earnings growth rate. A PEG ratio of one is considered standard, meaning its growth rate is incorporated in the stocks' price. A PEG ratio higher than one means the stock is trading at a premium to its growth rate, while a ratio less than one may mean the stock is undervalued.