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One of the factors that many investors take into consideration during the investment process is the price/earnings ratio of a company. However, many average investors do not know what this phrase means or what its importance is when looking at a particular stock. Consequently we are providing a generic description of this concept. Please keep in mind that this discussion is not designed to be complete in all material respects. It is being provided for informational purposes only. It should not be relied upon as legal or investment advice. If you have any questions concerning this concept, please consult an experienced legal or financial professional.
The price/earnings ratio (P/E) of a stock is arrived at by dividing the price of a stock by its basic earnings. The P/E ratio may either use the reported earnings from the latest year (call a “trailing P/E) or employ an analyst’s forecast of the next years’ earnings (called a forward P/E). The trailing P/E is listed along with a stock’s price and trading activity in the daily newspaper. For instance, a stock selling for $20 a share that earned $1 last year has a trailing P/E of 20. If the same stock has projected earnings of $2 next year, it will have a forward P/E of 10.
The P/E ratio, also known as the multiple, gives investors an idea of how much they are paying for a company’s earnings power. The higher the P/E, the more investors are paying, and therefore the more earnings growth they are expecting.
High P/E stocks — those with multiples over 20 — are typically young, fast growing companies. They are far riskier to trade than low P/E stocks, since it is easier to miss high growth expectations than low growth predictions.