P/E Ratio

The P/E ratio (price-to-earnings ratio) of a stock (also called its "earnings multiple", or simply "multiple", "P/E", or "PE") is a measure of the price paid for a share relative to the income or profit earned by the firm per share. A higher P/E ratio means that investors are paying more for each unit of income. It is a valuation ratio included in other financial ratios. The reciprocal of the P/E ratio is known as the earnings yield.

If Apple is trading at $90 a share, for instance, and earnings was $3 a share, its P/E would be 30 (90/3). That means investors are paying $30 for every $1 of the company's earnings. If the P/E slips to 27 they're only willing to pay $27 for that same $1 profit. This number is also known as a stock's "multiple," as in Apple is trading at a multiple of 30 times earnings.

The traditional P/E is what's known as a "trailing" P/E. It's for the previous 12 months. Also popular among many investors is the "forward" P/E -- It's for the coming year. Which is better? The trailing P/E has the advantage that it deals in facts -- its denominator is the audited earnings number the company reported to the Security and Exchange Commission. Its disadvantage is that those earnings will almost certainly change -- for better or worse -- in the future. By using an estimate of future earnings, a forward P/E takes expected growth into account. And though the estimate may turn out to be wrong, it at least helps investors anticipate the future the same way the market does when it prices a stock.

The biggest weakness with either type of P/E is that companies sometimes "manage" their earnings. It's also true that earnings estimates can vary widely depending on the company and the Wall Street analysts that follow it. So the P/E ratio should be viewed as a guide to you.