What Is a P/E Ratio of a Stock?
When investors buy shares of stock they do so for one reason: they want to make money, either from growth in the stock's value or from dividends paid to shareholders. The price to earnings, or P/E, ratio of a stock (sometimes called the earnings multiple) measures how much a share costs relative to the amount of money the company is making (how expensive the stock is, in other words). Properly interpreted, the P/E ratio of a stock can help you find bargains and avoid overpriced stocks.
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Identification
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The P/E ratio is just that: how much does the stock cost compared to how much a company has earned. There are two ways to calculate the P/E ratio for a stock. You can divide the market capitalization (price per share times the number of shares outstanding) by the company's annual net profit. The second method is to divide the price of one share of stock by the earnings per share. For example, if the per share price is $25 and the company earned $2.50 per share the previous year, the P/E ratio is $25 divided by $2.50 or 10. In situations where a company is losing money, it is considered to not have a P/E ratio.
Types
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The P/E ratio for a stock may be based on the company's earnings over the previous 4 quarters (called a trailing P/E) or on an estimate of earnings for the next four quarters, which is called a forward P/E. Typically, the P/E is updated every three months. Another variation is the relative P/E, which compares a single company's P/E to the average of a group of stocks, such as an index or a group of stocks in the same industry. The relative P/E is obtained by dividing an average of the other stocks' P/E ratios by the company's P/E. If the result is less than 1.0 the company's P/E is lower than the average in question while a result greater than 1.0 indicates a higher than average P/E.
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Significance
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At first glance interpreting a P/E seems simple. A low P/E indicates a stock that isn't expensive given the company's earnings and so it appears to be a bargain. While this is often the case, it's a mistake not to look any deeper since a variety of factors affect stock prices relative to earnings. P/E ratios in some industries are consistently lower than others. In the utilities sector, P/E ratios are typically lower than in most industries. Utilities are usually stable, rather than growth-oriented companies and investors look to them for good dividend income, not equity growth. This limits what investors are willing to pay for the stocks. In a growth industry like biotechnology you find higher P/E ratios since investors are willing to pay premium prices for promising growth stocks.
External Factors
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A company's P/E needs to be placed in context to be really meaningful. External factors can affect stock prices and hence the ratio. For example, when interest rates go up, investors can get better returns from bonds and other interest bearing securities and are not willing to pay as much for a stock, placing downward pressure on the price. A seemingly low P/E may not indicate a bargain, but simply reflect the influence of prevailing economic conditions. Other factors that can lower stock prices are high inflation and economic downturns or slowdowns, which increase investor uncertainty.
History
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Historical analysis of a company's P/E can be useful. To do this choose the trailing or forward P/E and divide by the P/E from a previous year. This produces a "relative P/E" that tells you if the stock's P/E has gone up or down over time. A result of less than 1.0 indicates the stock price is lagging behind earnings growth---a possible sign of trouble. Conversely, if this measure yields an answer greater than 1.0 it shows stock prices are outpacing earnings growth. This may indicate the company's future growth prospects have improved recently, making the stock more attractive to investors.
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