If financial formulas were celebrities, the price-to-earnings ratio (P/E) would be on the cover of every magazine.
People would scrutinize what it wore to the Oscars and watch breathlessly as it shaved its head before ending up in rehab.
But poor little P/E is nothing fancy or Botoxed like some of those other famous formulas. Instead, its charm is in its simplicity:
P/E = Price per share / Earnings per share
Yes, simple, elegant and steadfast, P/E is the Susan Boyle of financial formulas: a little frumpy and plain, but, man, can it sing.
First of all, the P/E ratio relies on two numbers that are really easy to get: share price and earnings per share (EPS).
They're readily available with even the most basic research. And if you passed third-grade math, you can probably roughly calculate a P/E in your head and amaze your friends at cocktail parties.
The relationship is simple, after all. If a stock price goes up or earnings go down, then the P/E ratio goes up. If a stock price goes down or earnings go up, then the P/E ratio goes down.
Second, the P/E ratio gets to the point. It answers the No. 1 question everybody has about a stock: Is this investment worth the price?
People often use P/E ratios to decide whether a stock is overpriced, underpriced or just right by comparing what you pay for a stock to how much money the stock actually produces. And once you know that, you can start making a little green.
[Click here to read about The #1 Rule Every New Stock Investor Needs to Know.]
The important thing to remember about the P/E ratio, though, is to focus on the 'E.' Earnings are the ultimate driver of stock prices.
Sure, people may say that a great management team, a swell marketing plan or a shiny new logo will make a company hit it big, but the earnings are either there to prove it or they're not. And when earnings go down, the P/E ratio goes up.
'The P/E ratio goes up' sounds like that would be a good thing. Sometimes it is, but at the core, it means that the stock price has gone up faster than earnings.
In other words, now you're paying more to get the same amount of earnings per share. Other stocks might sell you the same EPS for a lot less. And that doesn't make them bad stocks; it just makes them cheap stocks.
One way to use your P/E powers for good and not evil is to use the ratio to figure out what a stock price 'should' be after a company announces its latest earnings.
For example, if Company XYZ and most of its competitors have usually had a P/E ratio of eight, then when Company XYZ announces that its last 12 months of earnings per share total $1, everyone is going to multiply that $1 by eight to figure out what the stock price 'should' be ($1 x 8 = $8), assuming nothing else has drastically changed behind the scenes at the company.
Then they'll compare that to what the actual price is. If you can buy that $8 stock for $5, you probably should.
One of the other things to remember about P/E is that, like celebrities, it's fickle and hard to predict. Some folks (analysts) think they know what E will be, but they don't really know anything until the company announces its quarterly earnings.
Nonetheless, the 'E' in P/E is often based in whole or in part on 'forward earnings' or what I like to call 'dangerous assumptions.' So watch out. And remember what your parents said about what happens when you assume.
The Investing Answer: Ultimately, fickleness is nothing new in the finance world or the celebrity world, so most of us have learned to overlook P/E's occasional mood swings and bad outfits and just focus on the fact that it is a very talented ratio that usually produces hits. Which is why if Wall Street ever gets a Walk of Fame, P/E might get the first star.