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.
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|
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.