THE P/E is hands down the most popular ratio among investors. It definitely has its limitations (as we'll see in a minute), but it's also easy to calculate and understand. If you want to know what the market is paying for a company's earnings at any given moment, check its P/E.
The P/E is a company's price-per-share divided by its earnings-per-share. If IBM is trading at $60 a share, for instance, and earnings came in at $3 a share, its P/E would be 20 (60/3). That means investors are paying $20 for every $1 of the company's earnings. If the P/E slips to 18 they're only willing to pay $18 for that same $1 profit. (This number is also known as a stock's "multiple," as in IBM is trading at a multiple of 20 times earnings.)
The traditional P/E -- the one you'll find in the newspaper stock tables -- is what's known as a "trailing" P/E. It's the stock's price divided by earnings-per-share for the previous 12 months. Also popular among many investors is the "forward" P/E -- the price divided by a Wall Street estimate of earnings-per-share for the coming year.
Which is better? The trailing P/E has the advantage that it deals in facts -- its denominator is the audited earnings number the company reported to the Security and Exchange Commission. Its disadvantage is that those earnings will almost certainly change -- for better or worse -- in the future. By using an estimate of future earnings, a forward P/E takes expected growth into account. And though the estimate may turn out to be wrong, it at least helps investors anticipate the future the same way the market does when it prices a stock.
For example, suppose you have two stocks in the same industry -- Exxon and Texaco -- with identical trailing P/Es of 20. Exxon has a stock price of $60 and earnings of $3, while Texaco has a stock price of $80 and earnings of $4. They may look like similar investments until you check out the forward P/E. Wall Street is projecting that Exxon's earnings will grow to $3.75 a share -- 25% growth -- while Texaco's earnings are only expected to grow by 6% to $4.25. In that case, Exxon's forward P/E slips to 16, while Texaco would be valued with a forward P/E of 18.8. Assuming the estimates bear out, Exxon would clearly be the better buy.
The biggest weakness with either type of P/E is that companies sometimes "manage" their earnings with accounting wizardry to make them look better than they really are. A wily chief financial officer can fool with a company's tax assumptions during a given quarter and add several percentage points of earnings growth.
It's also true that quality of earnings estimates can vary widely depending on the company and the Wall Street analysts that follow it. The bottom line is that despite its popularity, the P/E ratio should be viewed as a guide, not the gospel.