P/E ratio
The P/E ratio is defined as the price per share of a stock divided by the earnings per share of the stock.
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Expanded Definition
The P/E ratio (or "PE") is probably the most common and widely used of valuation metrics. Every website displays it and many investing articles discuss it.
It is a quick way to look at the value of a stock. One way to view it is as how many years it would take for you to recover your investment principle from the earnings a company generates, assuming no change in those earnings. For example, if you were to buy a company for $5 million that had net income of $1 million each year, it would take you 5 years to break even on that investment. The PE would be 5.
Flavors of PE
Trailing PE
This is the most commonly discussed PE. Unless stated otherwise, you can probably assume that a displayed PE is a trailing PE. This is the one shown on sites such as Yahoo! Finance.
It is the current stock price divided by the earnings per share (EPS) from the last four reported quarters. To calculate it, go to a site such as Yahoo! Finance or Google Finance, look at the income statement summary pages, set the view to quarterly, and add up the EPS from the last four quarters. Then divide that total into the current stock price. For instance, if the company earned $0.37, $0.42, $0.26, and $0.22 in EPS over the last four quarters and the stock price was $17.33, then the PE would be $17.33 / $1.27 = 13.64. When the next quarter is reported, the oldest quarter's number is dropped so that the EPS used is always the four most recent quarters.
Current PE
This is the stock price divided by the consensus expected earnings for the current fiscal year, from analyst estimates. These are usually updated as the company reports earnings through the year, but actual company reported earnings are not used to calculate this.
To determine this one, go to a site such as Yahoo! or Google Finance or Morningstar, find the page which shows analyst expectations and look for the current year estimate of earnings. Divide that into the share price to get the current PE.
Forward PE
This is the stock price divided by the consensus expected earnings for next year, as opposed to the current year which is used in calculating the current PE. The same procedure is used to calculate this ratio, but use the estimated earnings for next year, not this year.
Investor Sentiment
The P/E is sometimes referred to as an *Investor Sentiment* indicator. The P/E will move minute by minute as the price changes, as earnings changes usually happen only once a quarter. As the P/E goes up, it shows that current investor sentiment is that the company is worth more, its future prospects are bright, and sellers are only giving up their stock at higher prices. A dropping P/E in an indication that the company is out of favor with investors.
The median stock in the S&P 500 Index has a P/E ratio of about 15. The PEG ratio, the ratio of P/E to annual growth rate is a useful derivative. If a PEG ratio of 1.0 is ideal, the median company on the S&P 500 should have a 15% annual growth rate. Many aim for that goal, but only some achieve it. A lower PE ratio implies a mature, low growth company. A very low PE implies that investors believe earnings are likely to decline in the future. High growth companies can justify higher P/Es, but P/Es over 30 are difficult to sustain with earnings growth. They are considered speculative. Similarly companies with no earnings have no P/E. They are often new companies or start-ups, sometimes with excellent prospects, but not yet earning a profit. Companies reporting losses have a negative P/E, but negative P/Es are rarely reported.
Price earnings ratio can also be calculated based on estimated or anticipated earnings for the coming year or even further out. Differences in the earnings number used often account for differences in reported P/Es. Read the fine print to determine what earnings number was used.
P/E should never be used alone in valuing a company because earnings are fluid and can change due to a variety of circumstances. A company with a P/E of 5 is not necessarily a better investment than a company with a P/E of 30. Sometimes there are good reasons for a P/E to be low or high. The trick to investing wisely is knowing when the market has it right and when it does not.
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