Valuation Ratios: Price/Earnings

The P/E is a company's price-per-share divided by its earnings-per-share. If McDonald's is trading at $34 a share, for instance, and earnings came in at $2 a share, its P/E would be 17 (34/2). That means investors are paying $17 for every $1 of the company's earnings. If the P/E slips to 10, they're willing to pay only $10 for that same $1 profit. (This number is also known as a stock's "multiple," as in McDonald's is trading at a multiple of 17 times earnings.)

The traditional P/E — the one you'll find in the newspaper stock tables — is what's known as a "trailing" P/E. It's the stock's price divided by earnings-per-share for the previous 12 months. Also popular among many investors is the "forward" P/E — the price divided by a Wall Street estimate of earnings-per-share for the coming year.

Which is better? The trailing P/E has the advantage that it deals in facts — its denominator is the audited earnings number the company reported to the Security and Exchange Commission. Its disadvantage is that those earnings will almost certainly change — for better or worse — in the future. By using an estimate of future earnings, a forward P/E takes expected growth into account. And though the estimate may turn out to be wrong, it at least helps investors anticipate the future the same way the market does when it prices a stock.

Pure hypothetical: Suppose you have two stocks in the same sector — McDonald's and a fictional restaurant rival we'll call Zendy's — each with trailing P/Es in the high teens. They may look like similar investments, until you check out the forward P/Es. Wall Street is projecting that Zendy's earnings will grow by 10% between 2005 and 2006 largely on the strength of the launch of its new, secret-recipe, fat-free French fries — while McDonald's earnings are expected to grow by only 5%. While both sport forward P/Es in the mid-to-high teens, Zendy's, which is growing annual earnings at twice the rate of the Golden Arches, would clearly be the better buy. In other words, you're buying a car that's twice as fast for roughly the same price.

The biggest weakness with either type of P/E is that companies sometimes "manage" their earnings with accounting wizardry to make them look better than they really are. A wily chief financial officer can fool with a company's tax assumptions during a given quarter and add several percentage points of earnings growth.

It's also true that quality of earnings estimates can vary widely depending on the company and the Wall Street analysts that follow it. The bottom line is that despite its popularity, the P/E ratio should be viewed as a guide, not the gospel.