Many factors go into decisions on buying or selling shares of a particular stock, but the price/earnings (P/E) ratio can be a helpful starting point for evaluating whether a company’s stock is under- or overpriced.
The P/E ratio is calculated by dividing a stock’s current price per share by the company’s earnings per share over a 12-month period. This ratio quantifies what investors may be willing to pay for one dollar of earnings.
For example, a P/E of 20 means an investor would pay $20 for every $1 the company earns over the 12-month period. By this standard, a stock with a P/E of 25 could be considered more “expensive” than a stock with a P/E of 20, regardless of the share price. A higher multiple also indicates that investors may expect higher growth from the company compared to the overall market.
Past and Future
There are two main types of P/E ratios. Trailing P/E is based on the company’s actual reported earnings per share for the previous 12 months. Because earnings are reported quarterly, that part of the equation will generally remain the same for the entire three-month period, but the stock price may change every trading day.
Forward P/E is based on the company’s projected earnings over the next 12 months. The forward P/E can also fluctuate with stock prices and as earnings projections are updated.
Trailing P/E is generally consider a more objective metric than forward P/E, because earnings projections are essentially opinions that may not turn out to be accurate. However, some investors prefer to focus on forward P/E, because a company’s past performance may have little to do with its future prospects.
Use Ratios Wisely
Knowing a company’s P/E ratio may provide some insight, but only if you use it to make appropriate comparisons. It is generally more meaningful to compare ratios of companies in the same industry or one company against the industry average. This is because P/E ratios can vary widely among industries and may also change for an entire industry as it faces challenges or goes in or out of favor with investors.
You might also compare a company’s current and past performance, but keep in mind that P/E ratios typically rise and fall with stock prices; if prices rise and earnings stay about the same, P/E ratios increase, and vice versa. So an increase or decrease in a company’s P/E ratio that moves with the broader market may not tell you much about the company’s performance.
Copyright 2006-Broadridge Investor Communication Solutions, Inc. All rights reserved.
Broadridge Investor Communication Solutions, Inc. does not provide investment, tax, or legal advice. The information presented here is not specific to any individual’s personal circumstances.
To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances.
These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable—we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.
*Non-deposit investment products and services are offered through CUSO Financial Services, L.P. (“CFS”), a registered broker-dealer (Member FINRA / SIPC) and SEC Registered Investment Advisor. Products offered through CFS: are not NCUA/NCUSIF or otherwise federally insured, are not guarantees or obligations of the credit union, and may involve investment risk including possible loss of principal. Investment Representatives are registered through CFS. Coastal Federal Credit Union has contracted with CFS to make non-deposit investment products and services available to credit union members.
CFS representatives do not provide tax or legal guidance. For such guidance please consult with a qualified professional. Information shown is for general illustration purposes and does not predict or depict the performance of any investment or strategy. Past performance does not guarantee future results.
Trust Services are available through MEMBERS Trust Company. CFS* is not affiliated with Members Trust Company.