P/Es are very, very important. We need to understand how to use them—and how to keep them in perspective. Let me give you a cabdriver’s take on this. A P/E stated as dollars just says how much you’re paying for each dollar of earnings. If a company has a P/E of 42, you’re paying $42 to get at one dollar of earnings. Likewise, if the P/E is 8, it means you’re paying $8 to get at one dollar of earnings.

To decide if a P/E for a particular company is good, we need to:

1. Pick a number we’re happy with—say, “I’ll buy any company with a P/E under 12,” or

2. Compare it to the market as a whole, or (3) compare it to stocks in the same sector, say high-tech or pharmaceuticals.

Let’s look at 2, as 1 is self-explanatory. Standard and Poor’s has an index of 500 stocks. It’s called the S&P 500. The combined P/E for these companies is in the high teens. You compare your company to this number and get a feel for how well your stock is doing.

You could also look at a smaller picture and compare your stock to other companies in the same business. There are so many variables in trying to get a handle on this information. One problem is that different reporting services use different time periods. For example, one newspaper may use “trailing 12 months” numbers to figure a company’s P/E. It could be accurate to the last decimal, but is it appropriate to make a judgment solely based on where a company has been? Are we not buying the future—what a company will earn? Some figures are on projected earnings. If we only used this number, would that be complete—as if anybody knows what a company will actually earn? Yes, analysts (for the company or independent) can make their best guess, but they often fall short or overstate earnings.

Probably the best gauge would be to take a blend of the “trailing” and the “projected earnings.” Many papers report it in some combination: say, trailing 12 and future 12 months. Many use six months back and six months’ future.

The P/E ratio is a mathematical formula. It is the current price of the stock, divided by the Earnings, as in Earnings Per Share. The Price of the stock, as you well know fluctuates all of the time. The EPS is set, or announced each quarter, in the company’s SEC filings.
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