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The price-to-earnings ratio, or P/E ratio, is a tool investors use to assess whether a stock is priced appropriately. Here's how it functions.

What is a P/E Ratio?

According to Terry Sylvester Charron, senior director of the Family Wealth Investment Advisor Group at BNY Mellon Wealth Management, "The P/E ratio indicates to investors how expensive or inexpensive a company's stock is based on its current earnings."

To calculate the P/E ratio, divide a stock's current share price by its earnings per share (EPS). EPS is determined by taking the company's earnings over the past 12 months and dividing it by the total number of outstanding shares.

What Does the P/E Ratio Reveal About an Investment?

Andrew Crowell, a financial advisor and vice chairman of Wealth Management at D.A. Davidson, explains, "The P/E ratio shows how much an investor is willing to pay for each dollar of the company's earnings."

For instance, Apple's (AAPL) P/E ratio at the time of writing is 32.9, according to Morningstar data. This indicates that investors are prepared to pay $32.90 for every dollar of Apple's earnings.

How to Use the P/E Ratio in Investing

The P/E ratio helps compare a stock to its industry peers or the broader market.

Crowell illustrates this by saying, "If all other factors are equal, an industrial stock with a P/E of 17 is more expensive than one with a P/E of 13. Assuming similar growth rates, revenues, and debt levels, the higher P/E stock is more costly."

As with most purchases, you want to avoid overpaying for an investment. Opting for stocks with lower P/E ratios can be a prudent investment approach.

Crowell emphasizes, "Buying stocks at the right price is crucial. Exercising discipline to avoid overpaying can help investors make wise investment choices."