How to use P/E as a valuation tool (Article)

P/E ratio is used as a measurement of the relative cost of the stock. The P/E ratio is equal to a stock's market capitalization divided by its after-tax earnings over a 12-month period. Whether the calculating for the whole company or a per-share basis, the value is the same.With a high P/E ratio, the market is more willing to pay for each dollar of annual earnings.

Previous year's price/earnings ratio are considered actual (using a historical price), current/next year price/earnings ratio would be estimates. In either case,' P ' is equal to the current price. Companies that are not currently profitable (negative earnings) do not have P/E ratio's.

When comparing acompany's P/E, one should look at comparing the ratio against similar companies. Different industries and even different companies have different P/E ratio's. Technology companies typically have above market P/E ratio's (approx double the average market P/E), while banks have typically have below market P/E ratios.

Understanding the P/E number

A P/E of 40, would mean that it would take 40 years for the investor to see a return on the investment. High P/E ratios can represent low recent earnings, whilst a low P/E ratio could imply low expectations or that the stock is undervalued.

It would be advisavle to also consider comparing the P/E ratio to the growth of earnings per share (P/E divided by growth rate). The resulting PEG ratio can aid the investor in determining whether investor expectations are reasonable given the companies past performance.