The price-to-earnings ratio, or P/E, is arguably the most popular method for valuing a company's stock. The ratio is so popular because it's simple, it's effective, and, tautologically, because everyone uses it.
Let's go through the basics of valuing a company's stock with this ratio and work out how this calculation can be useful to you.
Calculating the value of a stock
The formula for the price-to-earnings ratio is very simple:
Price-to-earnings ratio = stock price / earnings per share
We can rearrange the equation to give us a company's stock price, giving us this formula to work with:
Stock price = price-to-earnings ratio / earnings per share
To calculate a stock's value right now, we must ensure that the earnings-per-share number we are using represents the most recent four quarters of earnings. This is called the company's trailing-12-month earnings per share, and it can be found for most all public companies with a quick Internet search.
After looking up the company's trailing-12-month earnings per share, next we need to look up the company's P/E ratio. For the sake of understanding the ratio, you can use the P/E ratio listed on any of the many financial websites out there today, including Fool.com.
Finally, with these two numbers in hand, simply divide the P/E ratio by the earnings per share number and you'll have the company's current stock price. It's just that easy.
Using this method to improve your investing
If you use a company's current trailing-12-month earnings per share and P/E ratio, you aren't learning anything new about the stock. Your result will always match the stock's current price, which doesn't help you invest for the future.
However, by analyzing a company's future earnings potential and how the market values its competitors, you can use the P/E ratio to understand where you think the stock's price could be in the future.
For example, if the company has a major new product release coming next quarter, you could predict how that release may increase its earnings per share going forward. Most likely, your research will indicate a range of possible earnings per share predictions based on how well the product release goes.
You could also analyze the company's competitors to see how their current price-to-earnings ratio compare. If the competitor's P/E ratios are higher or lower than your company, then you could investigate why that is and what could change to drive their ratios either closer together or farther apart. You may determine that the there are no significant reasons and predict that the company's P/E ratio is likely to either rise or fall in the future to match the competition.
After you've completed your analysis, you can use the results to create a matrix to show where the stock price would be under various P/E ratio and earnings per share combinations.
Stock price matrix of possible P/E ratios and earnings per share
In the hypothetical example here, the first column shows the possible earnings per share numbers and the top row shows possible price-to-earnings ratios. The middle section of the chart shows what the stock price would be under each combination based on the aforementioned formula.
For a real analysis, the first column would be based on your analysis of the company's future earnings per share, and the top row would be based on your research of the competition.
This matrix tells you not just what the stock price would be in the specific outcome your research predicts, but also the stock price for a range of other outcomes.
It's impossible to predict the future, so there is no guarantee that any stock will perform as you predict. However, using the price-to-earnings ratio to value a company's stock in a variety of different situations is an effective way to understand the implications for all sorts of various outcomes. It's an easy and quick exercise to include in your stock research practices to take your investing to the next level.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at email@example.com. Thanks -- and Fool on!
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.