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Market Metrics: Understanding P/E Ratios

Is a stock 'cheap'? This quick calcuation will shed some light

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If you’ve started dabbling in the markets, you’ve likely come across the term “price-to-earnings ratio” or simply “P/E.” And if you’re anything like I was when first starting out, you’re also wondering what the heck it means.

youngInvestorsB.pngThe quick answer is that it’s the relationship between a company’s current share price and its earnings per share (hence price divided by earnings).

What you should do with this number is a bit more involved, but a lot more important.

P/E ratios are vital when evaluating a stock because they provide a sense of how a company is being valued by the investment community. Investopedia explains that the metric shows just “how much investors are willing to pay per dollar of earnings,” adding that “in general, a high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E.”

The specifics aren’t so simple.

To properly apply a P/E ratio when making a stock-buying decision, you also have to understand the nuances.

For one, there are two types of P/E ratios that typically get thrown around — “trailing” and “forward” — and they’re two very different animals. To get a sense of each, let’s walk through an example using everyone’s favorite fast-food pleasure: McDonald’s (MCD).

On Aug. 19, the struggling Golden Arches closed at $95.48 per share — that’s the “P” in your P/E ratio. Now, all we have to do is find the “E.”

For trailing P/E — “trailing” refers to the “trailing 12 months” — you compare the price to the total earnings of the most recent four quarters. McDonald’s past four quarterly EPS results are seen in the table below.

Month of Quarter End Earnings Per Share
September 2012 $1.43
December 2012 $1.38
March 2013 $1.26
June 2013 $1.38
Total $5.45

So, your trailing P/E ratio is $95.48 divided by $5.45, which gives you a trailing P/E ratio of 17.6.

And when the next quarter is reported in October, the oldest quarter’s number will be dropped.

The company’s forward P/E is a bit different, as you used Wall Street analyst expectations for earnings for the upcoming year. For McDonald’s, 2014 earnings are expected to total $6.11 per share. Substitute that in for the “E” in our equation, and you get a forward P/E of 15.6.

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