Price-to-earnings (P/E) ratio has long been a standard measure of a stock’s value – but there are more ways than one to measure it.
Are you using the most appropriate measure?
P/E ratio is a company’s current stock price divided by its annual earnings per share.
For example, a stock trading at $40 per share with earnings per share of $2 would have a P/E ratio of 20 ($40 divided by $2).
A stock priced at $20 per share with earnings per share of $1 would also have a P/E ratio of 20 ($20 divided by $1).
P/E ratio is effective in expressing how much investors are paying for the value a company creates.
The problem is, there are more ways than one way to calculate P/E ratio, and all have their flaws.
Trailing P/E ratio, for example, is based on known earnings over the past year.
So, if a company’s past year’s earnings were unsustainably high, today’s P/E ratio might be deceivingly low.
On the other hand, another P/E ratio measure uses earnings forecasts, which may change in response to economic conditions.
Another trick used when calculating P/E ratio is to use so-called operating earnings instead of earnings as defined by regulators – and there’s no legal definition for operating earnings.
That said, stocks still appear cheap, at least by trailing P/E ratios, as of late September 2011.
At that time, at least 81 large U.S. companies had single-digit P/E ratios, according to Thomson Reuters.
In general, investing in stocks with low P/E ratios, whatever the measure used, may be a good idea because P/E ratios show what investors are prepared to pay for every $1 of a company’s earnings – and this, in turn, reflects the stock market’s view of the outlook for the company.