When professionals use fancy words or lingo, it can scare us silly. It certainly gets me. But fancy lingo doesn't mean that something is complicated and out of the spectrum of understanding. When you actually research it, most terms and "formulas" in the investment world are actually pretty simple. The same can be said of P/E ratios.

What Is a P/E Ratio?

A P/E ratio, otherwise known as a price-to-earnings ratio, is simply a way to gauge how a company's earnings stack up against its share price. Think of it as a way to gauge how expensive a stock is. It might sound technical but it's pretty simple math. To find a stocks P/E ratio, you simply divide the stock's market value per share (or stock price) by the company's earnings per share. Let's look at the two most common types of P/E ratios, the ones I use, and look at a quick example of how it works.

The two types of P/E's that are most commonly discussed are the trailing P/E and forward P/E.

Trailing P/E Ratio

A trailing P/E ratio goes off of the stocks past full-year earnings. For example, let's look at Macy's (M) - Get Reportfourth-quarter 2018 and full-year earnings results. Remember, we need their earnings per share for this; not their net income. The retailer reported earnings of $3.56 for the full year ended Dec. 31, 2018. As I wrote this, the stock was trading at $25.23. So then we just plug in our number. (Ugh...I sounded like a math teacher just now.)

Trailing P/E ratio=value of the stock/earnings per share

Trailing P/E ratio=$25.23 a share/$3.56 in earnings per share

Trailing P/E ratio=7.08

So Macy's is trading at 7.08 times its trailing 12-month earnings. It's not as complicated as it might feel at first. The benefit of a trailing P/E is that you can gauge how expensive the stock is relative to its recent earnings performance. The drawback being that we only live in one direction, and it most certainly isn't in the past.

Forward P/E Ratio

For a forward P/E ratio, you have to find out the company's guidance for the future. Say Macy's diluted earnings per share guidance for 2019 is $3.05 to $3.25. (I'm making this up.) It should be noted that this figure excludes the company's possible charges; impairments or other costs, so actual reported GAAP earnings could be lower. If they don't provide clear guidance, you can also use analyst estimates to try to figure out an idea for valuation, though I prefer a company's own forecasts.

Let's be kind and say that we believe Macy's will deliver $3.25 per share for 2019. We simply take that number, and plug it in the equation like we did with 2018's full-year earnings.

Forward P/E ratio=value of stock/earnings per share

Forward P/E ratio=$25.23 a share/$3.25 in earnings per share

Forward P/E ratio=7.76

So the forward P/E ratio of Macy's stock is currently 7.76 times its forward full-year earnings for 2019. It's important to remember that unlike trailing earnings, we don't know for sure that Macy's will hit that number. Since their guidance excludes some costs, it's likely that the earnings will be lower.

Why Is a P/E Ratio Important?

The benefit of a trailing P/E ratio is that you get an idea of how this stock trades relative to its earnings. More simply put, you find out how much of a premium people are willing to pay for the stock. You can also decide whether you want to pay that premium for the stock. If you noticed, Macy's forward P/E ratio went up slightly compared to its trailing P/E. That's because Macy's 2019 guidance is lower than its 2018 results. They are predicting they'll make less per share, meaning there is less pie to be spread around to shareholders. If a share price stays the same, but the earnings per share decrease, that will drive the price-to-earnings ratio high. That means to get your hands on some Macy's shares, you're paying a high premium relative to its actual earnings potential.

Think of it this way. If Macy's (M) - Get Report has a forward P/E of 7.76, that means you're going to pay $7.76 for every $1 of earnings that you gain access to by buying stock. No one likes paying a premium over what something is actually worth, so it's usually better to stray away from stocks that are trading at 100 times earnings. The only real reason to pay a big premium for a stock is if you believe the future earnings will grow at a rate that will justify the current price down the road.

Example of Using a P/E Ratio

Say Company A costs $10 a share, and has full-year earnings of $1 a share. If you've learned anything, you know that the P/E ratio for that stock is 10; i.e., $10 a share/$1 earnings per share. So to buy the stock today, you have to pay a premium of 10 times earnings.

Down the road, we believe that Company A can finish out 2019 with $4 a share in earnings. That would give it a forward P/E ratio of 4. That's a much better premium isn't it? So we buy it because we're getting it for a deal relative to future earnings.

2019 ends and the Company reports earnings of $4 a share. If the stock doesn't move at all, the actual value of our shares is 4 times earnings. However, stocks will usually move if they prove they can make more money for investors. A lot of stocks have ranges of value that they'll trade at. Let's say Macy's traditionally trades at around 10 times earnings (a P/E ratio of 10). When the company reports that $4 in earnings, the stock would theoretically get pushed toward $40 a share; or 10 times earnings. Your investment just gained 30% thanks to your astute skills.

This is an extremely simplified example. Stocks trade at different multiples for a great many reasons, but it explains how valuations using price to earnings can help to give you a better gauge of what a stock should be worth on paper relative to its earnings.

Over the short term, there are stocks that trade at absurd valuations relative to their actual earnings. Take Netflix (NFLX) - Get Report for example. The stock commonly trades at well over 100 times its actual earnings results. Why? The answer is largely speculation. Investors believe that Netflix will create such meaningful earnings growth down the road, that the current share price is a long-term discount. It's very similar to what we did in our example. We paid the premium for Company A in the hopes that its earnings would increase to $4 a share. The difference is that we paid a relatively low multiple of 10 for the stock, vs. Netflix's high P/E ratio. If it turns out that we were wrong, and earnings don't live up to expectations, those high-valued stocks have a higher probability of falling to lower share prices. Fairly valued stocks are usually more stable.

Key Takeaways

In summation, trailing P/E ratios will give you an idea of what investors are willing to pay for a stock relative to its earnings. Forward P/E ratios help you gauge how a stocks potential future earnings stack up against its share price. Both of these are very useful! But remember that market volatility can disrupt this type of logic in the short term; leading to all kinds of swings and P/E ratios for stocks.

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