Your Friend, the P/E Ratio

Ever look at some stock listings, see price-to-earnings (P/E) ratios for various companies, but then scratch your head, not knowing what to make of all the numbers? If so, relax. It's all probably simpler than you think.

The P/E ratio is a measure that compares a company's stock price to its earnings per share (EPS) for the previous 12 months. You can think of it as a fraction, with the stock price on top and the EPS on the bottom. Alternatively, tap the price into your calculator, divide by EPS, and voila -- the P/E.

Consider Wanton Punctuation (ticker: ?#$@!), trading at $30 per share. If its EPS for the last year (adding up the last four quarters reported) is $1.50, you just divide $30 by $1.50 and get a P/E ratio of 20. Note that, if the EPS rises and the stock price stays steady, the P/E will fall -- and vice versa. For example, a stock price of $30 and an EPS of $3 yields a P/E of 10. You can calculate P/E ratios based on EPS for last year, this year, or future years.

Since published P/E ratios generally represent a stock's current price divided by its last four quarters of earnings, they reflect past performance. However, intelligent investors focus on future prospects. You can do this by calculating forward-looking P/E ratios. Simply divide the current stock price by coming years' expected earnings.

Many investors seek companies with low P/E ratios, as this can indicate beaten-down companies likely to rebound. (Of course, a low P/E may also indicate a beaten-down company that's just begun its beating.) Low P/Es might be attractive, but understand that P/Es vary by industry. Car manufacturers and banks typically sport low P/Es, while software and Internet-related companies command higher ones. Don't compare kumquats to kiwis, and don't stop with the P/E ratio. There are many other numbers to examine when studying a stock.

You can learn more about investing in our highly regarded How-to Guides and online seminars, too. They can help you learn to make sense of financial statements, among other things.