Why the price-earnings ratio matters

This measurement can be a key to help investors select stocks.

  • By Miranda Marquit,
  • U.S. News & World Report
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When you start research stocks, and trying to decide where to put your money, you're likely to come across the term price-earnings ratio.

So, what is the price-earnings ratio, or P/E, and what can it tell you about a stock?

A simple look at P/E

At its most basic, the P/E is a way to value a company by looking at its current share price in relation to its earnings per share. The idea is that you can use the ratio to compare different companies in the same industry, or even see what type of performance a company has relative to its past performance.

There are different versions of ratio, including the trailing P/E, which bases calculations on earnings over the past 12 months, and the forward P/E, which is more about earnings guidance than it is past numbers.

One of the easiest ways to look at P/E is to choose a point in time and go from there. This can at least offer you a snapshot.

No matter how you look at it, though, the price-earnings ratio can give you a basis for comparison as you decide whether a stock is overvalued or undervalued.

How to calculate P/E

The formula for calculating P/E is fairly simple: P/E = market value per share/earnings per share

You'll have to go through a multi-step process to figure out the earnings per share, however. First, you'll have to get the total value of a company's outstanding shares (information you can get from reports) and divide it by the outstanding shares.

For example, if a company's total profit is $15 billion and it has 5 billion outstanding shares, the result is $3 in earnings per share. Now, you need to take a look at the current stock price, which might be $45. You have what you need to plug into the formula: 45/3 = 15

So, the P/E is 15.

What does the P/E ratio mean?

The simplest explanation is that it means that an investor is willing to pay a certain amount for $1 in current earnings. A P/E of 15 indicates that investors are likely to pay $15 to receive $1 in current earnings.

As a stock analysis tool, the P/E is often used to try to figure out if a stock is overvalued or undervalued. In general, the higher the number, the more likely it is that a company is overvalued.

A lower number, on the other hand, might indicate that the market undervalues a stock. Many value investors like to look for P/E ratios that are lower, in the hopes that they can get a good deal.

Compare P/E carefully

It's important to be careful when using P/E, though. First of all, it should be used in an apples-to-apples comparison. Different industries often have different ratios. For example, one sector might see an average P/E of 35 while another sector might commonly end up with ratios around 20.

Your most significant comparisons are likely to be between companies in a sector. You can compare a stock's P/E with other stocks in the sector, or even compare it with the P/E average for the entire sector.

Being able to see where a stock fits in can be a big help when you're making decisions.

It might also be useful to compare a company's P/E today with the ratio it had at similar points in the past. You can get an idea of whether the stock is becoming overvalued, or if it hasn't yet been properly recognized.

Don't forget that it's possible to take averages. You could take the average of a company's P/E from 2009 until 2019, and then use that to make comparisons to long-term averages of other companies or with the sector as a whole.

And, of course, whether you use trailing or forward P/E can make a difference in the outcome as well.

P/E can be a valuable analysis tool when you're trying to find value. While it's not the only ratio that can be used (there are others, like price-book and price-sales), it is one of the simplest ratios to determine and use in an analysis. Many stock screeners include P/E, and it can be a good way to find likely candidates for your portfolio.

Just make sure you use it carefully and consistently.

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