by Kenneth W. McCarty

Created on: June 17, 2008

Price to earnings ratio (P/E ratio sometimes referred to as the multiple) is the current price per share divided by a years worth of earnings per share (EPS) for a particular stock. It is an important indicator of perceived value for a stock. Often it is used to compare two different stocks in the same sector (or two sectors in a given market) in an effort to find the better "deal". It sounds simple enough, but in practice it is a bit more complicated.

Not all publicly traded companies have earnings (they can have losses instead), yet these stocks clearly have value. P/E in such circumstance cannot be relied upon when it is negative or undefined. Much more important for estimating the current value of this type of equity are such things as cash on hand and other tangible assets. Some investors may anticipate that the stock will eventually have real earnings and add perceived value to the stock based on this assumption.

A backwards or "trailing" P/E takes into account only the earnings for the past year. In a "Bull Market", this form of P/E can be considered an indicator for the floor of a stock's share price. Instead of estimates, the earnings stated in the last 4 quarterly reports are publicly known and are generally not subject to change at a whim (except when future reports become current or the company is forced to make restatements by the SEC or an unfavorable audit).

Many investors prefer to use a forward P/E instead. This speculative potential of the stock's perceived worth that may or may not be added into the price anticipates and uses earnings over the next 12 months. Market forces determine how reliable such calculated predictions are and adjust prices accordingly. Company track records and economic influences are used by traders to judge the reliability of those numbers.

The difference between the two values that forward and backward P/E represent helps create volatility in the price of the stock as traders try to forecast earnings. Different stocks trade over different ranges of multiples for a variety of reasons. Many stocks in mature industries historically tend to trade between multiples of 10 and 20. Technology stocks that have real earnings often trade between multiples of 20 and 40. A company that has significant revenue growth may deserve a much higher multiple than this because the implication is that notable future earnings growth will continue to occur. When track records for 10Q quarterly reports are consistently positive, investors tend

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