How the Price to Earnings Ratio is Calculated

by John Schroeder

The price to earnings ratio (P/E ratio) represents a company’s current share price compared to its earnings per share. Commonly referred to as the earnings multiple, the P/E is commonly used by investors to compare and analyze stocks, as well as determine if a company is under or overvalued.

There are many different versions of the price to earnings ratio which are often used to understand past, present, and future valuations.

How the Price to Earnings Ratio is Calculated

The most common price to earnings ratio that is tracked is known as the trailing P/E. This calculation uses the earnings per share (EPS) from the past four quarters and the current share price. The equation to run the calculation is highlighted below.

P/E = Share Price / Earnings Per Share

A stock that is currently trading at $20 per share that reported earnings over the past 12 months of $1.00 per share would have a P/E = 20. This calculation is represented below –

Trailing P/E = $20 / $1.00 or 20

If the projected earnings for the company were expected to reach $1.25 in the next 12 months, an investor could calculate the future P/E using the same equation. In this scenario, the future P/E would equal 16. This is important information for an investor as the current share price may seem like a good bargain compared to the future.

Future P/E = $20 / $1.25 or 16

There are also some price to earnings calculations that use a combination of past and future earnings projections. One version takes the earnings results from the past two quarters and adds them to projections from the next two future quarters.

Since there are plenty of different ways to calculate and represent a P/E, it is important for the investor to understand the differences.

How to Determine a Stock’s Value

Some stocks have high P/E ratios while others have lower valuations. This does not mean that the stock with the lower P/E is more valuable at its current share price compared to the stock with the higher earnings multiplier.

Each type of stock is valued differently in the market and investors need to understand this. Growth stocks that are expected to see above average earnings increases tend to have much higher P/E ratios than those of establish companies that are not growing as fast. The important thing to remember is that even though every stock has a P/E ratio, there are different valuations that are acceptable within the market depending on many other factors.

Final Thoughts

The price to earnings ratio, also called the earnings multiplier, is a representation of a company’s current share price to its reported earnings per share. The P/E of a company can be calculated for past and future earnings as well as a combination. Investors must understand just exactly what type of P/E numbers they are looking at before making any type of investment decision or comparing it against other stocks.

Do you use the P/E ratio when determining the value of a stock? Do you prefer using the future or trailing calculation?

Published or updated December 13, 2010.
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