Finding the P/E Ratio

• In order to understand how a stock's value is determined by the P/E Ratio, you first need to know how to calculate this ratio. The formula is: Price per Share/Annual Earnings Per Share. To get the Annual Earnings Per Share, you need to perform this calculation: Net Income for the most recent 12-month period/Number of Shares Outstanding. The P/E Ratio can also be found by dividing a company's market capitalization by its total annual earnings.
  
  

Crunching the Numbers

• You use these numbers and calculations to determine whether the price of a stock is keeping with the company's earnings. This ratio will tell you whether the stock's price is undervalued, reasonably priced or inflated and, therefore, the real value of the stock in question.
  The P/E ratio allows you to view a particular company's growth prospects. Higher ratios indicate a public consensus that a company will continue to experience growth. Lower ratios can indicate that a company's growth prospects are not good, or that they have simply leveled off and are functioning at a steady pace.
  
  

The Big Picture

• Once you understand how the P/E Ratio has been calculated, you can study the patterns of valuation for a particular stock. Companies with zero earnings and those with losses will typically have an "undefined" P/E Ratio. Those with a ratio between 0 to 10 are thought to be bad growth prospects. P/E Ratios from 10 to 17 are considered to be fairly valued. When the ratio goes higher, it can signify that this stock is considered to be a "growth stock," or that the stock is overvalued.
  
  

Heads Up

• When studying P/E ratios, it is imperative to keep in mind that these numbers can be manipulated like any other indicator of a stock's worth. The manipulation does not necessarily indicate any intent for deception, but may simply be based upon which numbers are used to calculate the P/E ratio. You need to perform your own calculations, and also study the evaluations from trusted, neutral financial reports in order to gain the clearest perspective on P/E ratios. While the P/E ratio is an important indicator of a stock's value, it is not the only tool you should use when evaluating a company and its stock.