For new investors, “P/E”  might as well mean “physical education”. Good news, though, as there’s nothing extraterrestrial about “P/E” — in fact, it’s one of the most widely used terms and tools in the investment playbook.

The price-earnings ratio, or P/E ratio, helps you answer a simple, fundamental question when you’re trying to decide if you should buy a stock:

Are you paying too much?

But how does the price-earnings ratio indicate if a stock’s price represents its actual value?

What is the price-earnings ratio?

The name says it all: The price-earnings is the ratio between a company’s stock price and the company’s earnings. It’s a calculation, expressed as the current stock price divided by earnings per share:

As for the variables in the equation, the share price refers to the current market price for a stock. Earnings per share, or EPS, is a measure of a company’s profitability. We’ll spare you another math lesson, but it’s calculated by dividing a company’s net income, or profit, by its total number of outstanding shares.

Most commonly, the P/E ratio is calculated using earnings calculations from multiple previous quarters. This is called a “trailing P/E”. (That’s in contrast to the “forward”, or “future P/E”, which is calculated using estimates of future earnings.)

Why the P/E ratio is important, and how to use it

If you’re trying to decide whether or not to buy a company’s stock, the P/E ratio is an invaluable tool. It allows investors to quickly gauge a company’s profitability relative to its share price.

Without digging deeper into a company’s books and reports, the P/E ratio will give you an idea of whether the company is earning money, and how much those earnings stack up to its valuation.

If the P/E ratio is high, that means that the stock price is more, per share, than a company is earning. That’s not necessarily a bad thing, however. It’s not uncommon for young and promising companies to have a high P/E ratio, particularly companies that still have a lot of venture capital and investment cash to work with, or that are still in growth mode.

A low P/E ratio, on the other hand, could be a sign that a company’s growth is slowing down, or that it’s reached a certain stage of maturity. Again, this isn’t necessarily a negative thing, but could simply signify that a company is settling into its place in the market. In some cases, It could also be a sign that a stock is undervalued.

Shortcomings and alternatives

The P/E ratio isn’t the final word, however.

There is yet another ratio you can use, called the PEG ratio (price/earnings to growth ratio). This ratio factors a company’s growth rate into the mix, giving you a glimpse of how a stock is expected to behave in the future.

Ratios can also vary between companies and industries. So, for context, you it’s a good idea to  compare ratios between firms in similar sectors.

You wouldn’t want to compare Walmart to Boeing, for example. Or Google to Northrop Grumman. An appropriate comparison would be Walmart to Amazon, or Google to Yahoo.

And according to Morningstar, P/E ratios can be distorted by one-time events, such as inflated or depressed earnings, and cyclical business changes.

Finally, don’t assume that the P/E ratio is a substitute for doing diligent research on a stock or company. Just because the ratio looks promising and a stock is relatively cheap doesn’t necessarily mean it’s a good investment.

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