Low P/E ratio can be attractive – or a warning

You probably see price-to-earnings (P/E) ratios everywhere, but you may not have a good grasp of what they are.

The P/E ratio is a measure that compares a company’s stock price to its earnings per share (EPS) for the previous 12 months. Think of it as a fraction, with the stock price on top and the EPS on the bottom. Alternatively, tap the price into your calculator, divide by EPS, and voila – the P/E.

Consider Buzzy’s Broccoli Beer (ticker: BRRRP), trading at $40 per share. If its EPS for the last year (adding up the last four quarters reported) is $2, just divide $40 by $2 and you’ll get a P/E ratio of 20. Note that if the EPS rises and the stock price stays steady, the P/E will fall – and vice versa. For example, a stock price of $40 and an EPS of $4 yields a P/E of 10.

You can calculate P/E ratios based on EPS for last year, this year or future years. Since published P/E ratios generally represent a stock’s current price divided by its last four quarters of earnings, they reflect past performance. Intelligent investors should really be focusing on future prospects by calculating forward-looking P/E ratios. Simply divide the current stock price by coming years’ expected earnings per share, available via many online stock quote providers (like at http://quote.fool.com).

Many investors seek stocks with low P/E ratios, as they can indicate beaten-down companies likely to rebound. But a low P/E may also indicate a company that’s about to fall further. Low P/Es can be attractive, but remember that P/Es vary by industry. Car manufacturers and banks typically sport low P/Es (often in the single digits), while software and Internet-related companies command higher ones (often well north of 30).

The P/E ratio is useful, but don’t stop your research there. There are many other numbers to examine when studying a stock – such as its sales and earnings growth rates, debt level and profit margins. Compare companies to their competitors, too.

Ask the Fool

Q: What’s the difference between a “growth” stock and a “value” stock? – P.M., Spokane

A: When describing stocks, the adjectives “growth” and “value” often aren’t too meaningful, and aren’t even exclusive of each other. After all, an ideal company would probably be increasing sales and earnings rapidly (growth) and also be priced below what’s it’s really worth (value). A company that begins increasing sales significantly may be dubbed a growth stock, and if its stock price ever seems low, it might be deemed a “value” play. Growth and value are often in the eye of the beholder. Successful investors will do well to look for both in their investments.

Ask a financial question of Fool co-founders David and Tom Gardner on The Motley Fool Radio Show on National Public Radio. Call anytime toll-free at 866-NPR-FOOL.

My dumbest investment

Like many others, the Internet introduced me to investing. I was too intimidated to sit down with a stockbroker, but online I could trade and be in control. The only problem was, I bought when the market was at its highest point during the tech bubble. I rode it down and learned a lesson: Don’t listen to the analysts on TV. Many came out of the woodwork and recommended buying those dot-com companies with no earnings. It was my fault for being greedy and a short-term investor. I no longer care whether the CEO of GE has a head cold today and the stock is down a penny. As a kid, I used to watch my aunt read the financial section of the newspaper every Friday, to see how her stock did during the week. Once a week was enough. She stayed the course, bought what she knew and did well. Sometimes the best investment advice is from someone who has been there. – M.T., Birmingham, Ala.

The Fool Responds: Your aunt did it right. Behind many successful investors you’ll find patience, discipline and a long-term focus.