The Money Question: How to Calculate a P/E Ratio

Bartiromo helps makes sense of the
stock market. Courtesy of CNBC.

When Wall Street evaluates a company's stock, the important number is not the price per share, but how the per-share cost of the stock measures up within the context of the company's earnings. That number is called the price-to-earnings, or P/E, ratio and, says Maria Bartiromo, CNBC anchor and author of Use the News: How to Separate the Noise from the Investment Nuggets and Make Money in Any Economy (HarperBusiness, 2001), "Basically, it's the price tag that the market puts on a stock."

• The P/E ratio is calculated by dividing the price of a stock by its earnings per share. The P/E ratio may either be based on the reported earnings from the past year (called a trailing P/E) or on an analyst's forecast of the next year's earnings (called a forward P/E). For example, a stock selling for $20 a share that earned $1 a share last year has a trailing P/E ratio of 20. If the same stock has projected earnings of $2 next year, it will have a forward P/E ratio of 10.
• The trailing P/E is listed along with a stock's price and trading activity in the daily newspapers. The forward P/E is found in analysts' reports and company press releases.
• The P/E ratio is a vital measurement because it's consistent for all companies across all industries. As of December 31, 2003 the average stock in the S&P 500 sells at about 24.9 times earnings. (Historically, the S&P P/E is about 30.) If the market values that company below what it values an average company in the same industry, that could be a buying opportunity. Conversely, if a company's P/E ratio is at a lofty level compared with its competition, it could mean that the stock is overvalued and is risking a tumble. You can check S&P's indices at their Web site.