A price to earnings or P/E ratio is used to evaluate how expensive or cheap, the stock market/stock may be at any given time. Just as an appraiser can give you an estimate of the value of your home, the P/E ratio is a tool that can be used to estimate the fair value of the stock market.
As the name implies, to calculate the P/E, you simply take the current stock price of a company and divide it by its earnings per share (EPS).
There are two most popular ways to calculate the P/E.
Most of the time, the P/E is calculated using EPS from the last four quarters. This is known as the trailing P/E. However, this method gives a less accurate reflection of the company’s growth potential.
The P/E is also calculated using EPS for the next four quarters. This is known as the forward/leading P/E. Though this method will better reflect the growth potential, its dependency on the expected earnings leaves room for a lot of error.
Trailing P/E is based on actual earnings and, therefore, is more accurate. However, stock prices are constantly moving while earnings remain fixed.
As a result, forward P/E can sometimes be more relevant to investors when evaluating a company.