Wall Street’s most powerful number is also one of its most understood. But in the next ten minutes, I’m going to show you everything you need to know to efficiently analyze this important metric – and potentially profit as a result.

You’ve probably heard a lot of people talk about the P/E ratio. It’s one of the most popular fundamental analysis numbers out there. Moreover, it has earned a reputation as one of the key ways we value stocks. And in my book, it’s one you simply can’t avoid.

In a nutshell, the P/E ratio gives us a clue into the real value of a stock. It does so by taking the price of the stock and dividing it by the company’s earnings over the last 12 months. Spelled out:

P/E Ratio = Stock Price / Yearly Earnings

Let’s say XYZ is selling for $20 a share. Over the last 12 months, the company has earned $2. As a result…

XYZ P/E Ratio = $20 / $2 = 10

Since XYZ stock is currently selling for $20 and over the past 12 months the company has earned $2 a share, XYZ’s P/E ratio is 10.

So getting the P/E number is pretty straightforward. But by itself, figuring that XYZ has a P/E of 10 doesn’t really do much for us. It’s just the starting place that makes valuing a company easier. Without it, we’re sort of left in the dark about whether a stock’s price is really worth what people are paying for it. So now we need to dig deeper.

Using the P/E Ratio Makes Valuations Easier

Think about it a second. In our example above, XYZ is selling for $20 a share. But how do we know that $20 a share is a fair price for XYZ?

First off, we take XYZ’s P/E and compare it with other companies in XYZ’s industry. If other companies in the same industry carry P/Es lower than XYZ’s, then we say the XYZ is “overvalued.” Let’s look at a real-life example…

As you can see from this graph, IBM carries a P/E ratio of 12.8. That means its share price is valued at nearly 13 times its last 12 months of earnings. The average P/E for companies in IBM’s sector is just 10.7. As a result, we can figure that IBM is slightly overvalued.

In other words, compared with other companies in its marketplace, you’re going to pay a little bit more for IBM than other players. And the P/E ratio helped us get to this determination very quickly and with very little fuss.

Since IBM is slightly overvalued, does that mean we shouldn’t buy the stock? Not at all. While the P/E ratio tells us something about IBM’s value, it’s not the whole story.

IBM (NYSE:IBM) is an industry leader. So just as with any big-name brand, you’re going to pay a little bit more for it. And in my book, the slight difference between IBM’s P/E of 12.8 and the sector’s 10.7 is well worth the premium.

Now, if you are looking to invest in a company with lots of solid growth prospects, you’re quickly going to see that the company’s P/E ratio could easily be much higher than IBM’s 12.8. And the reason that’s so is pretty simple…

Companies with high growth prospects command a higher P/E ratio because investors believe the growth rate is going to translate into higher stock prices down the road. And since stock prices reflect what investors think is going to happen to a company, these high-growth companies usually carry higher P/Es.

Should these higher P/Es drive us away? Not necessarily. Companies with higher growth rates are going to deserve higher P/Es. But the higher P/Es have to be justified by other solid fundamental factors, like exciting new products, top management and good financial operations.

Look at Both the “P” and “E” for Historical Comparisons

In addition to comparing a company’s P/E with its sector, I also like comparing its current P/E with what’s happened in the past. Let’s take another look at XYZ…

Currently, the company carries a P/E ratio of 10. But let’s say that a year ago, XYZ’s P/E was 8. So what does this tell us about the value of XYZ?

Looking just at these numbers, I would conclude that XYZ is becoming higher valued. In other words, investors like the growth prospects for XYZ and are bidding up the stock’s price to prove it.

But before we pop open the champagne, it’s a good idea to take a look at what’s happened to both parts of XYZ’s P/E over the last year.

If the “P” – the price – of XYZ has gone up and XYZ’s “E” – earnings – have gone up, then we’re looking at a growth company that’s commanding a higher stock price. In my book, that’s a positive.

But if the “P” of XYZ has gone up and the “E” has remained the same – or, worse, gone down – then investors are piling into XYZ without much care for earnings. While that’s not always a bad thing, a lower “E” with a higher “P” is certainly cause for concern in my book.

P/E for the Broader Market

No matter what kind of company you’re looking at, it’s always a good idea to have an idea of where its P/E stacks up against the stock market as a whole. And a good way of doing that is to look at historical P/Es for the S&P 500. Take a look at the next graph.

As you can see from this graph, the P/E ratio for the broader U.S. stock market fluctuated between 17 and 25 from March 2005 to September 2008. In fact, the average P/E for the S&P 500 was 19.5 during this period.

In December 2008, the S&P 500’s P/E ballooned to 61. With my data going back to 1936, this is by far the highest P/E on record. And with the mess the market and the economy were in, it goes without saying that this astronomical P/E wasn’t driven by high growth and excellent earnings.

So what’s the takeaway? Simply, that when looking at P/Es for the broader market, it’s important to pay attention to long-term trends with exceptions – like last December’s quarter – taken into consideration.

Drawbacks to the P/E Ratio

Just like every indicator in the book, the P/E has drawbacks. And you need to keep these in mind when you use this popular ratio.

First off, the bottom of the equation – the earnings part – is calculated by the company based on accounting rules. And while many of these rules are in place to protect investors, there’s little doubt that figuring out how a company arrives at its “E” is a monumental task.

Companies can also massage numbers to make their “E” more attractive. And I don’t have to tell you that the unscrupulous ones aren’t above just plain falsifying their books.

But that’s not all…

The P/E ratio can also be calculated using different time frames for the earnings part. The one we’ve used here – the trailing 12-month historical P/E – is the most common, but sometimes the P/E is based on projections that haven’t happened yet. As a result, projected P/Es are less reliable to me than historical P/Es. And you have to know which kind of P/E you’re dealing with.

Best wishes,
Wayne Burritt

Source: The Secret of Wall Street’s Most Powerful Number