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What Is P-E Ratio In Stock Market?

written by: Brian Nelson•edited by: Rebecca Scudder•updated: 6/21/2011

Understanding what a P-E Ratio is provides insight into making money by investing in stocks using fundamental analysis.

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    The definition of P/E ratio is the price to earnings ratio. Specifically, a company's PE ratio is the price of its stock divdided by its earnings per share.

    The P/E ratio of a company is a one of the most important indicators in fundamental anaylsis, because it shows how "cheap" or "expensive" a company's stock is. Theoretically, a compny with a low P/E ratio is a better deal than a company with a high price to earnings ratio. Stocks with a low P/E ratio cost less for the same amount of earnings or dividends that stocks with a high price-to-earnings ratio.

    However, there are, of course, many other considerations when picking stocks for profitable trades.

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    Trailing P/E vs. Forward P/E

    There are multiple ways to look at a stock's price to earnings ratio. One method, is called the trailing P/E and it is calculated by using the earnings from the most recent year past, called the trailing year.

    Another way to calculate a stock's P/E is to use the forecast of analysts for the company's earnings for the coming year. This is called the forward P/E.

    Both kinds of P/E have their advantages and disadvantages.

    The advantage of the trailing P/E is that it is calculated with real results and not the predictions of analysts which can be wrong, sometimes by a lot. The disadvantage of the trailing P/E is that it tells you what the stock "should" have been worth based on earnings from the past.

    The advantage of a forward P/E ratio is that it is not based on a company's past performance. After all, all lot of things can change in a year and a company might be doing much better, or much worse now that it was last year. The disadvantage of a forward P/E ratio is that it depends basically on a guess as to what the company's earnings will be since there is no way to know for sure how much a company will earn in the future.

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    Buy Stocks and Make Money

    Making money investing in stocks involves being able to buy stocks that are a good value and sell them later at a higher price. Using a P/E ratio allows one to gauge how good of a value a stock currently is.

    A stock with a high P/E ratio is not a good value on a fundamental earnings basis, while a stock with a low P/E ratio is a good value on a fundamental basis.

    Deciding which kind of P/E to use for figuring out good stock investments can be eliminated by finding stocks which have good value P/E ratios for both the forward P/E and the trailing P/E. That means the stock is a good value no matter which earnings one looks at.

    It is important to know that many other factors go into determining whether or not a stock is a good investment. A stock's P/E may be high because there are solid expectations of large future growth (a growth stock) or the stock's P/E may be low because its future prospects are dim (a low price but not a good value).

    Always use a company's P/E ratio as just one factor in determining whether or not it is a good stock market investment.