Understanding P/E ratios

FOOL’S SCHOOL

It’s best to buy stocks when they’re undervalued. But figuring out whether a stock is undervalued is easier said than done. Even smart investors can disagree on how to decide. One handy metric offering a rough idea of valuation is a stock’s price-to-earnings (P/E) ratio.

You can find P/E ratios for stocks already calculated for you at financial websites, but doing the math yourself is fairly easy: To calculate a P/E, take the stock’s current price per share, and divide it by the earnings per share (EPS) over the past 12 months. (For a forward-looking P/E, divide by the expected EPS over the coming year.)

For example, imagine that Holy Karaoke Inc. (ticker: HYMNS) is trading at $48 per share. If its EPS for the last four reported quarters (“trailing 12 months”) totals $3, divide $48 by $3, and you’ll get a P/E of 16. A P/E ratio will rise when the stock’s price increases or EPS falls — and vice versa. So if Holy Karaoke is trading for $48 but its EPS is only $2, its P/E ratio will be 24 ($48 divided by $2).

The P/E ratio tells you how much you’d pay per dollar of earnings if you bought the stock. In finance-speak, a stock with a P/E of 24 might be referred to as “trading at a multiple of 24.”

When assessing a company’s P/E, compare its trailing and forward-looking P/ES. If it’s expected to report higher earnings next year (a good thing), the forward P/E ratio should be lower. (Note that P/E ratios are not calculated for unprofitable companies, as they have no earnings and you can’t divide by zero.)

In general, the lower the P/E, the more attractive the stock’s valuation. P/E ranges can vary by industry, so it’s best to compare a stock’s P/E with those of peers in its industry, or with its own five-year average P/E. Also, don’t focus too much on that particular ratio. Look at other numbers as well, such as revenue and earnings growth rates, profit margins, debt levels and the trends you see in each.