The price-to-earnings (P/E) ratio is very important in analyzing a potential stock investment because it’s one of the most widely regarded barometers of a company’s value, and it’s usually reported along with the company’s stock price in the financial page listing. The major significance of the P/E ratio is that it establishes a direct relationship between the bottom line of a company’s operations — the net profit — and the stock price.

The P in P/E stands for the stock’s current price. The E is for earnings per share (typically the most recent 12 months of earnings). The P/E ratio is also referred to as the earnings multiple or just multiple.

You calculate the P/E ratio by dividing the price of the stock by the earnings per share. If the price of a share of stock is $10 and the earnings (per share) are $1, then the P/E is 10. If the stock price goes to $35 per share and the earnings are unchanged, then the P/E is 35. The higher the P/E, the more you pay for the company’s earnings.

Why would you buy stock in one company with a relatively high P/E ratio instead of investing in another company with a lower P/E ratio? Keep in mind that investors buy stocks based on expectations. They may bid up the price of the stock (subsequently raising the stock’s P/E ratio) because they feel that the company will have increased earnings in the near future.

Perhaps they feel that the company has great potential (a pending new invention or lucrative business deal) that will eventually make it more profitable. More profitability in turn has a beneficial impact on the firm’s stock price. The danger with a high P/E is that if the company doesn’t achieve the hoped-for results, the stock price can fall.

You should look at two types of P/E ratios to get a balanced picture of the company’s value:

  • Trailing P/E: This P/E is the most frequently quoted because it deals with existing data. The trailing P/E uses the most recent 12 months of earnings in its calculation.

  • Forward P/E: This P/E is based on projections or expectations of earnings in the coming 12-month period. Although this P/E may seem preferable because it looks into the near future, it’s still considered an estimate that may or may not prove to be accurate.

Looking at the P/E ratio offers a shortcut for investors asking the question, “Is this stock overvalued?” As a general rule, the lower the P/E, the safer (or more conservative) the stock is. The reverse is more noteworthy: The higher the P/E, the greater the risk.