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Understand Ratio To Evaluate Your Investment For Financial Wealth

P/E: A Tool For Evaluating A Stock's Price

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.

By younginvestor.com