Understanding a stock's P/E ratio (or price/earnings ratio) and why it's important to know..
how do I calculate a P/E ratio..?
in order to obtain a stocks P/E ratio.
P over E ratio divide price by the earnings of a single stock so.. if the price of a stock is $40 bucks a share and the EPS (earnings per share over the last 12 months) is $2 bucks put the price over the earnings and divide to get your P/E ratio.. this is gives us $40 price over $2 earnings.. or 40/2.. so the P/E ratio is 20 |
trailing EPS..?
note: when referring to the EPS > over the last 12 months we call this >> "trailing EPS" (or annualized earnings per share) P/E varies by industry:
note: a P/E ratio should be compared relative to it's industry average.. use Yahoo! Finance - Industry Browser to determine what industry your specific stock is in and find the industry average P/E. enter they ticker symbol of your specific stock and Yahoo! Finance will locate the industry specifics. |
Ok.. so I can figure out a P/E ratio and compare it to the industry average no problem, but what does this mean??
Companies that have a higher P/E ratio than others (in the same industry of course) can be expected to grow in the future.
however,
bargain hunters keep an eye out for stocks with low P/E ratios because a company with a P/E ratio of 20 is a more expensive stock than a stock with a P/E ratio of 10.. something to keep in mind when determining value of stock based on P/E ratio.. then again we can take this one step further.. a stock with a low P/E ratio can however have a downfall.. that low P/E ratio may not only mean that the stock is cheap.. but may also mean that the company will have slow growth. which is why you should compare the P/E ratio to the growth rate.. in comparison > the 2 should be equal. In summary.. a low P/E is good to look for because it means the stock is cheap.. but it doesn't always mean that you should invest because it's cheap; you need to ensure that the company isn't headed for bankruptcy or slow growth. |
compare the current P/E (the one you got with the trailing EPS).. compare it to the forward P/E
first of all.. the forward P/E is whatever the stock price is trading at divided by whatever the stock is expected to earn of the next four quarters.. (expected to earn) .. (expected earnings)
current price over expected earnings (annual).. this will give you your forward P/E.. if the forward P/E is lower than your current P/E.. this means that the future earnings are expected to be HIGHER than the current annual earnings. (the company will likely earn more in the future) if the forward P/E is higher then your current P/E.. this means that the company is expected to earn LESS in the following year -- not a good thing! (we want the company to earn more) |