Explaining the P/E Ratio

One of the most common measures that investors use to evaluate a stock is its price-to-earnings (or P/E) ratio. The P/E ratio is calculated by dividing a stock's price by its per-share earnings for any given year. And while it's not a foolproof way of gauging a stock's value, it is a good place to start. Let's take a look at a simple example:
Suppose ABC Corporation is expected to earn $2.00 per share in the coming year and its stock is currently trading at $50 per share. The P/E ratio of ABC's stock shares, therefore, is calculated to be 25 ($50/$2.00 = 25). It must be noted that the P/E here was calculated based on the company's expected earnings; in other words, their earnings estimate. This is known as a forward P/E. Some investors choose to use a company's previous 12-month earnings instead, since that number is a certainty. And although this isn't necessarily wrong, it's probably better to use the forward P/E because it provides an idea of how much of a premium other investors are willing to pay for a company's future earnings. A higher P/E ratio indicates higher expectations for continued earnings growth. In other words, investors will pay more money based on the company's current earnings in the hope that it's future earnings will make the current price that they paid seem low.
P/E ratios are most helpful when compared against other P/E ratios. For instance, you may want to examine a stock's historical P/E range – how high and low its P/E has been in the past. You might also compare it with the P/Es of other similar companies. Or, you could compare the P/E ratio of a particular stock to the P/E ratio of a market index, such as the Standard & Poor's 500. These comparisons will give you an idea of where a particular stock stands with regard to its own history, its peers, and the stock market as a whole.
P/E ratios can be industry-specific, based on the characteristics of a particular group of stocks. For example, homebuilders and financial companies typically trade at below-market P/Es because their businesses tend to be fairly mature. It must also be remembered, however, that just because a stock has a relatively low P/E, it isn't automatically a great buy. Other investors may be aware of some company problem and therefore shying away from the company's shares in response. The actual fact of the matter is that a low P/E can be either a good or bad indicator. As stated earlier, it's a place to start your evaluation of a stock.
The P/E can also be used to look at how quickly a company's earnings have been growing over the past few years. In order to do this, you simply take the company's yearly earnings results and subtract them from the next year's earnings results. Then, divide that number by the earnings number that you just subtracted. The result – once the decimal point is moved two places to the right (remember you high school math?) – will be the percentage of earnings growth that year.
Revisiting ABC Corp., let's say that they earned $1.00 per share in 2001 and $1.30 in 2002; the calculations would be thus: $1.30 - $1.00 = $0.30. Then: 0.30/1.00 = .3 (and move the decimal point, yielding 30%). So, in 2002, ABC's earnings grew by 30 percent. By repeating these calculations for several years in a row, you can determine an average annual growth rate, which will give you a better idea of a company's long-term performance.
Keep in mind that a company can experience no growth, or even negative growth, for one or more years. It should also be noted that calculating this type of information for a company with an especially erratic earnings history likely wouldn't be very useful to you. You'll need to dig much deeper in order to get a clear picture of a stock's true worth.