The P/E Ratio

The P/E ratio, sometimes referred to as just “multiple”, is one of the oldest and simplest financial ratios. It is used to compare the valuation of different stocks to each other and the market as a whole.

P/E ratio = stock price / earnings per share

What you’re calculating is basically the amount of money investors are willing to pay per dollar of the company’s earnings. The long-term market average P/E is about 15.

There are several variations of the P/E ratio.

• Trailing P/E: earnings of the last 4 quarters are used to calculate P/E.

• Current P/E: earnings of the current year are used, this includes past earnings and estimations. This is the most common way of measuring P/E.

• Forward P/E: estimated earnings of next year are used to calculate the P/E ratio. Be wary of this method as it can be very unreliable, and makes the stock look cheap.

The P/E ratio can tell you at a glance how a company is valuated. If a company has a high P/E it’s either because investors are expecting high growth or because the stock is overvalued. If the company has a low P/E its either because investor expect a downturn in earnings, or because the company is undervalued.

P/E ratios should be compared to the market as a whole, or even better, to their corresponding industries to get an idea of whether a company is over or undervalued.

One must keep in mind that companies with high expected earnings growth tend to have higher P/E ratios than other companies. Because earnings growth plays such a big part in a company’s P/E ratio investors sometimes look at a company’s PEG ratio.