price-to-earnings ratio (P/E) provides a useful clue about
what investors think a stock is worth. It can help you decide
if a stock is over- or underpriced.
The P/E in the
newspaper is based on a company's earnings per share for the
most recent 12 months, so it is called a trailing P/E. Since
the paper shows you both yesterday's price of the stock, as
well as yesterday's P/E, you could use simple math to find the
company's reported earnings. For example, say you owned shares
in ABC, Inc. The share price for ABC, Inc. was $30 and the P/E
was 20. Simply divide the price of ABC's stock by the P/E to
find the earnings per share ($30 ÷ 20 = $1.50). The P/E of 20
tells you that investors were willing to pay $20 for every
dollar of ABC's earnings. This can be an important sign of
what investors have been thinking about ABC's stock. Investors
may think that a stock with a high P/E is expensive. That may
not always be true. In some cases, a high P/E may indicate
that the company has been growing faster than similar
companies and could offer greater growth potential. But in
others, a high P/E could be a warning sign that a company's
earnings may be falling.
Likewise, a stock
with a low P/E may or may not be a bargain. Investors may have
knocked down the stock price because of bad news about the
company or its industry. The company's financial health could
get better or worse. A low P/E indicates only that a company's
stock price looks cheap compared to its reported earnings.
As you can see,
the price-to-earnings ratio can mean different things. That's
why it's just one of the tools portfolio managers use to
evaluate a stock.