I understand that P/E ratio stands for - Company's share price to per-share earnings. But I do not understand how it works?

To calculate PE

• Find out what is the current price per share of the stock -- A
• Find out what is the earnings per share of the stock -- B
• PE = A / B

How to interpret PE

If the PE is 20, it means for every dollar earned by the company, an investor is willing to pay 20 dollars for that dollar of earnings. The higher the PE, it means that investors are willing to pay more for that dollar of earning. You may ask yourself, why would anyone pay 20 dollars for one dollar of earnings? You are paying for the potential of higher earnings in the future which would generally translate to stock price appreciation (capital growth).

Price to earnings ratio is a measurement of valuing the company relative to the earnings per share. So if your PE ratio is 15, you'd expect that for every dollar invested, it will take 15 years for the company to make that dollar back. As the company makes money, they may decide at their discretion to retain the profit for future expansion, repay debt, or distribute part or all of it to you. If they distribute in the form of dividends, that would be the dividend yield. So a stock of P/E 15 with a yield of 4% would pay you your $1 invested over 25 years (1/0.04=25).