Price to Earnings (P/E) Ratio Basics

One of the most widely used ratios is the P/E ratio (price/earnings). Despite some of its disadvantages, it is favored by most investors for its easy of understanding and calculating. P/E gives investors information on the market valuation of a company's earnings.

In order to calculate it, you should divide the price-per-share of a company by its earnings-per-share. For example, if company ABC has a price per share of $40 and its earnings per share are $2, and then the P/E of this company will be 20. How is this result interpreted? "20" represents the amount of money investors are willing to pay for every $1 the company makes in earnings.

Price to Earnings (P/E) Variations

There are several types of P/Es. One of them is the trailing P/E. It is the one most often cited in newspapers and other stock tables. It is calculated by dividing the price of the stock by the earnings-per-share that has been made over the past 12 months.

Another P/E variation is the so called forward P/E. It is calculated by dividing the price of the stock by the estimate for the earnings-per-share for the future year. The estimates used are those made by the Wall Street.

Trailing P/E vs. Forward P/E

Trailing P/E has its advantages over the forward P/E. One of them is that in the denominator of the formula by which it is calculated contains the audited earnings number, which has been reported to the SEC. However, these numbers are not constant, which means that in the near future a change in a positive or negative direction will be experienced.

Forward P/E includes considerations about the expected growth through the use of future earnings in the calculations. Even though the possibility that the projected estimates may not coincide with the ones that are actually reported at the end of the year, forward P/E gives a general view on the future performance of the stock.

When you compare two companies that look as if they offer the same future potentials, a calculation of the forward P/E of the companies may drastically change your view.

However, both the trailing and the forward P/E have a major drawback. Namely, many companies tend to manage their earnings so that they present them more appealing to potential investors. By manipulatively adjusting and managing the tax considerations of the company, the financial officers may add several additional percentages to the earnings growth ratio in order to attract further investments.

No matter how you view the usefulness of P/E you should not overlook it when you judge a company. You should include it as part of your analysis and consider it as guidelines toward more educated investment decisions.

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