The
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 and fifty cents 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. |