P/E Ratios Explained

The price-to-earnings (P/E) ratio is a measure that compares a company's stock price to its earnings per share (EPS), usually for the previous 12 months. Think of it as a fraction, with the stock price on top and the EPS on the bottom. You can tap the stock's price into your calculator, divide by EPS, and voila - the P/E. The ratio is calculated for you at many online stock research sites, such as http:// finance.yahoo.com.

Consider Gas Prices Inc. (ticker: ARMLEG), trading at $40 per share. If its EPS for the last year (adding up the last four quarters reported) is $2, just divide $40 by $2 and you'll 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 $40 and an EPS of $4 will yield a P/E of 10. (Savvy stock types might say that such a stock is "trading at a multiple of 10.")

You can calculate P/E ratios based on EPS for last year, this year or future years. Published P/E ratios generally reflect past performance. Intelligent investors should really focus on future prospects by calculating forwardlooking P/E ratios. Simply divide the current stock price by the coming years' expected EPS.

Many investors seek stocks with low P/E ratios, as they can indicate beatendown companies that may rebound. But a low-P/E stock can always fall further. Low P/Es can be attractive, but remember that P/Es vary by industry. Car manufacturers and banks typically sport low P/Es (often in the single digits), while software and Internet-related companies command higher ones (often north of 30).

The P/E can give you a clue as to whether a stock is undervalued or overvalued, when you compare a stock's current P/E to its historic range. But don't stop your research there. There are many other numbers to examine when studying a stock - such as its sales and earnings growth rates, debt level and profit margins. Compare companies to their competitors, too.