Using the Price-Earnings Ratio to Assess Stock Value

By Stock Research Pro • March 21st, 2009

The Price-Earnings Ratio is a valuation ratio to measure a company’s current share price against its earnings per-share. Often referred to as the “multiple”, the measure indicates how much investors are paying for each dollar of the company’s earnings. Generally speaking, a high P/E indicates that investors expect the company to achieve higher earnings growth in the future. The P/E ratio is usually compared to companies within the same industry. While there are several different ways to calculate this measure, the Trailing P/E is the most commonly used because it is based on actual company earnings.

Earnings-Based Valuations

Most investors determine the value of a stock through company earnings, which are simply the money remaining after the company pays all its expenses. To arrange for fair comparisons, investors look at earnings of a per-share basis, the EPS. The price/earnings ratio is the best known and most widely-used of earnings-based valuation measure.

Importance of the P/E Ratio

When investors like a company, they will drive up its share price and, by extension, it P/E ratio. Comparing the P/E ratio of that company against its competitors can help determine whether how reasonable that stock is currently priced. A high PE means that company must consistently grow its earnings to meet these investor expectations as falling short of these expectations will cause the stock price to fall.

Price/Earnings Calculations

Trailing P/E is calculated by dividing the current stock price by the company’s earnings per share for the past 12 months. This is the most commonly used P/E measure and, because it is based on actual earnings, it is seen as the most accurate. A trailing P/E is calculated based on the four most recent quarters for the company.

Forward P/E is calculated using forecasted earnings for the company. The forecasted earnings used can either be for the next 12 months or for the next full-year fiscal period. The forward P/E is not seen as reliable as the trailing P/E because it uses estimates for future earnings. It can, however, provide benefit to investors as they work to predict the future performance of a company to determine the worthiness of a stock investment.

Limitations of the P/E Ratio

While P/E ratios offer a quick way to assess value, they should offer you just one data point in making your investment decisions. A P/E that is measured using trailing earnings (which may have been strong) does not necessarily indicate strong future earnings.


The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.


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