A common metric used by stock investors is the price-to-earnings ratio, or P/E, expressed by saying the stock is some number times (X) earnings.
Identification
A stock trading at 20X earnings has a share price 20 times the current or previous year's net earnings per share.
Function
Publicly traded companies report profits as "earnings per share." The P/E ratio gives investors an indication of how the stock price relates to companies' profitability.
Calculation
Current stock price divided by the most recent four calendar quarters of earnings determines the P/E ratio. If stock is $60 and the company earned $3 per share over the past year, 60 divided by 3 shows the stock is trading at 20X earnings.
Considerations
P/E ratios can compare stock valuations. If Company A is $50 per share and trading at 15X earnings and Company B is $30 per share but trading at 25X earnings, Company B has a higher value in relation to earnings.
Significance
P/E ratios can indicate a stock's value. If company earnings grow at 30 percent per year but the P/E ratio is 20X earnings, it may be undervalued. If the P/E ratio and growth are nearly even, the stock is fairly valued, according to SmartMoney.com.
Potential
Calculating the P/E ratio using projected earnings for next year is a "forward P/E." StreetAuthority.com warns of errors with such projections, and suggests using forward P/E and other metrics to evaluate stock.