Price Earnings Ratio

The best way investors can evaluate a stock is the price earnings ratio. Learn what it is and how to use it.

In today's stock market, our 10 year-old bull market unfortunately seems to be turning bearish. With the Dow Jones industrial average nearing 11,000 and with a new high tech start up announcing a public offering every day, investors want more and more guidance on what's a good buy.

With more Americans investing in the stock market, it's also a good time to look at the No. 1 investing fundamentals.

It might seem like it's harder to pick worthwhile stocks now. After all, there are just so many, and everyone "" from your dentist to your minister "" seems to have an opinion on the matter. But the best way investors have to determine the value of a stock they are thinking of buying or selling hasn't changed. It has always been and still is the price-earnings ratio.

In the investment world, it's referred to simply as "P-E." Think of it as a stock's price tag, because it tells you as an investor how expensive the stock is.

The ratio has long been considered the No. 1 way to evaluate a stock. It compares the price the stock is selling at to the company's earnings per share, or the amount the firm earns on each share held by the public.

Calculating the ratio is easy. Simply divide the price by earnings per share. Newspapers, financial Web sites and corporate annual reports often have P-E already calculated, of course.



Basically, the ratio shows how much of a premium, or how many times earnings, you will pay to own part of that company. Conversely, you could say it also shows how much of a discount you are getting for an undervalued stock.

So, the P-E of a stock that trades at $60 and has earnings per share of $3 is 20. In other words, for every $1 of earnings, you as an investor are paying $20. Another way to put it "" and you hear this a lot from brokers and fellow investors "" would be to say the stock is trading at 20 times earnings.

In the past, stock gurus have maintained that a good P-E falls somewhere between 15 and 30.

Of course these days with stocks "" especially high-tech start ups trading sometimes well above $100 and posting no earnings, this is a moot point. The P-Es are huge. Investors and would-be investors are left depending on their instincts to determine if a company is going to post earnings and be worth the investment down the road.

Speaking of the future, another good measure to consider is the forward P-E. It simply uses a company's or analysts' earnings estimates for the next four quarters to calculate future P-E.

For the most complete P-E picture you could then look at trailing P-E. Simply use earnings per share and price figures for the last four quarters.

Picking and buying stocks is hardly an exact science. However, with the price-earnings ratio, along with data on the forward P-E and trailing P-E investors undoubtedly are better armed to make the best investment decision.

© High Speed Ventures 2011