3.2.3. Price/Earnings Ratio and Earnings Yield
EPS forms the denominator in the all-important price/earnings (P/E) ratio, which is a critical driver of stock price.
For example, a stock with EPS of $1 and a share price of $15 has a P/E ratio of 15. Like EPS, the P/E ratio specifically measures the value of common shares. It excludes preferred shares. You should also know that in an investment banking context, fully diluted EPS will be used. Elsewhere, it might be basic EPS.
The formula given above is the most common version, but there is another version that sometimes shows up on the exam too. In the above formula, both the numerator and denominator are in per-share form. If you multiply each one by fully diluted shares outstanding, the ratio remains the same, and you get this equally valid formula:
When you encounter this alternative version, there’s a chance the numerator might say “market cap” instead of “equity value.” We discuss these two terms, and the relationship between them, in the section on valuation metrics below.
Stocks with low P/E ratios are thought of as “cheaper” than stocks with high P/E ratios. (A high price/earnings ratio is often the hallmark of a growth stock, for which anticipated future growth has already been priced in by the market.) The price/earning