Price/earnings (P/E) ratios are a common measure of stock value, both for individual stocks and the overall market. Calculating a P/E ratio is straightforward - it is simply the price of a single share of stock divided by the company's per-share earnings. However, P/E ratios can be calculated using different earnings numbers. Trailing P/E ratios, which are typically reported in newspapers, use earnings per share for the most recent four quarters, while forward P/E ratios use forecasts of future earnings per share.
The difficulty is deciding what a reasonable P/E ratio is for a particular company or for the overall stock market. For individual companies, investors' expectations about future earnings affect the P/E ratio. Confidence that a company will improve its profitability or remain profitable generally results in a higher P/E ratio. If profits are threatened or weak, the P/E ratio is likely to drop. P/E ratios for the overall market change based on broad market conditions and investors' views about how desirable stocks are compared to other investments.
There is no absolute measure of what P/E ratio should be paid for a given company with a given growth rate. P/E ratios can fluctuate significantly over time and among companies and industries. It generally helps to follow the P/E ratios of stocks that interest you, along with companies in similar industries, to develop a feel for how the P/E ratios fluctuate. Reviewing a company's P/E ratio for prior years can also be helpful.
One way to evaluate P/E ratios is to consider a company's current P/E ratio divided by its historical P/E ratio. If it is much lower than 1, you might want to investigate why. If the value is much higher than 1, carefully assess whether you want to invest at this time. You may want to wait until the P/E ratio returns to a more historical level.
You can also divide a company's current P/E ratio by the market's overall P/E ratio. If that figure is much higher than 1 (and thus higher than the overall market), you should evaluate whether the company's prospects justify that valuation.
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