Understanding the P/E Ratio

QADoes a low P/E ratio indicate that a stock is going to go up? — F.W., St. Augustine, Florida Not quite. The price-toearnings ratio is a simple fraction, dividing a stock’s current price by a year of its earnings per share (EPS). If Sisyphus Transport Corp. (ticker: UPDWN) is trading for about $60 per share and has a trailing EPS of $3, its P/E ratio is 60 divided by 3, or 20.

The number shows how much you’re paying per dollar of earnings. Thus, all other things being equal, a P/E of 15 is preferable to a P/E of 25, because you’d be paying a lower “multiple” of earnings.

A low P/E ratio doesn’t guarantee future growth. It tends to reflect a possible bargain — or a company on shaky ground. A steep P/E can reflect an overvalued stock that’s more likely to stall or decline than to keep rising.

Note, though, that P/E ratios vary by industry and that they rely on EPS, which can be manipulated to some degree by management. So expect low P/E ratios in capital-intensive industries such as manufacturing, and higher ones in lighter and fast-growing businesses, such as software. Only compare apples to apples. Be sure to evaluate other measures, too.

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QCan you recommend any good books on value investing? — G.O., Adrian, Michigan

ATry “The Little Book of Value Investing” by Christopher H. Browne (Wiley, $25), “Value Investing: From Graham to Buffett and Beyond” by Bruce Greenwald et al. (Wiley, $22) or “The Intelligent Investor” by Benjamin Graham (Collins, $23).

“One Up on Wall Street” by Peter Lynch and John Rothchild (Simon & Schuster, $17), meanwhile, offers a good introduction to investing. Want more information about stocks? Send us an email to foolnews@fool.com.