Using the Price to Earnings Ratio

The price to earnings ratio (or P/E Ratio), is a fundamental analysis technique used to estimate the relative value of a stock. The ratio is defined as the "market price per share" divided by the "earnings per share". It tells you how much you have to pay for a dollar of a company's earnings.

Typically, this ratio is seen as a reflection of optimism regarding a companies future growth prospects. Analysts also use P/E ration to evaluate the general markets, but more on that later.

There are actually 3 different variations you need to be aware of:

  1. Trailing 12 Months (i.e. Trailing PE)
  2. Forward 12 Months (i.e. Forward PE)
  3. Trailing PE from Continued Operations
All these variations use the current market price per share. The difference between the three is in how you calculate earnings per share.

Trailing Price-Earnings Ratio

This is the most common way to calculate P/E ratio, because it reduces seasonal fluctuations in earnings. Things like the holiday season can have a big impact, which makes one quarter a bit slim in the data department.

So the "E" in trailing P/E ratio uses "reported net income" from the most recent 12 month period, divided by the weighted average number of common shares for the same 12 month period.

Companies can choose their own financial year (called a fiscal year), making the direct comparison of quarterly earnings between companies difficult.

Forward Price-Earnings Ratio

Forward PE ratio uses the predicted or expected net income over the next 12 months as earnings and divides that number by the current number of shares outstanding.

Trailing Price to Earnings Ratio from Continued Operations

The trailing PE ratio can also be calculated using "operating earnings" divided by the weighted average number of common shares in issue during the 12 period. "Operating earnings" do not include earnings from discontinued operations, extraordinary items (e.g. windfalls and write-downs), and/or changes in GAAP accounting methods.

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