by Steven Mars

Created on: November 05, 2008   Last Updated: August 26, 2010

Price to earnings ratio (also called earnings multiple) is defined as the price of a stock per share divided by the earnings per share for the last 12 months (EPS). For example, if Acme Inc. has earnings of $20,000 and 16,000 shares, it has an EPS of 1.25. If this stock sells for $25.00 per share and the earnings per share is $1.25, then the P/E ratio is $25.00/$1.25=20, which is about average. The reciprocal of the

P/E ratio is the earnings yield. It is quoted using percentages. The P/D is the price to dividend ratio, which is the ratio of the price of a stock to the dividend of the share. Dividends are money paid to its shareholders by corporations. Dividends are paid when there is a profit unless it is invested back in the business.

There is also a predicted P/E ratio, which is an estimate of what it will be in the next 12 months. A high P/E ratio is an indication that higher earnings are expected. But because the probable earning potential of some industries is higher than others, the P/E ratio should only be used as a comparison against other stocks in the same industry. There is an improved EPS called the diluted EPS. It tries to take into account how many shares will exist if all the stock options, warrants, preferred stock, convertible bonds, etc. are performed. This should increase the P/E ratio by increasing the number of predicted shares and lowering the EPS. Dividing by a lower EPS will increase the P/E ratio. One thing to take into account is if the price of the stock increases at the same rate as the earnings, then the P/E ratio stays the same. Another type of P/E ratio uses earnings forecasts for companies by professionals.

This will predict what the P/E ratio will be when the forecasts take place. A forecast for an increase due to expected demand will theoretically cause an increase in the P/E ratio. Also news of a discovery of a way to increase the speed of production will cause an increase in the P/E ratio. Of course if the prediction is wrong, it might turn out to be a bad investment. This is what makes taking forecasts by professionals to estimate P/E ratios hard to do safely. Another type of P/E ratio uses the previous earnings by a company to calculate the P/E ratio. This could work if the data is interpreted correctly.

It should be taken into account that the P/E ratio is much lower than average due to the current recession that was triggered when Congress did not sign a "Bailout" measure for the stock market. It was later signed after a few adjustments were made. Finding the best stock to invest in might be a stock with a low P/E ratio that will improve in the future for a reason found before enough people find out to increase the price of the stock.

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