Learning Mathanese: How to Calculate the P/E Ratio

Math investing
Math investing

Math: the four-letter word you can say on TV yet so reviled that people go great lengths to avoid it, even when they know doing so puts their financial well-being in peril.

Wait! Don't click away. Today brings part two in a continuing series that spotlights the major computations found here at DailyFinance. Or, as we'll call it, a short course in Mathanese -- aka the numbers behind investing's (and life's) big equations.

Don't worry, there's nothing too complicated here, despite how difficult and intimidating professional money managers and Wall Street talking heads make it seem. We're talking about math most 10-year-olds have learned upon graduating fifth grade. And today, it's all about the P/E ratio.

The Two Things That Matter Most: Price and Earnings

As with all buyers of things, investors like shorthand. Like the P/E ratio: investing shorthand for the cost of buying a claim on a company's earnings.

See, investors are also owners. Buying a share of stock means buying a piece of a business. Each "share" has a claim on profits, so when public companies report quarterly, they report the amount earned per share -- the amount that owners would be entitled to if all profits were paid out rather than reinvested for growth.

Say you read that Google (GOOG) trades for 18.9 times earnings. The numbers represent the P/E ratio, and the ratio represents the premium per share you must pay in order to lay claim to a share of Google's $28.12 in earnings reported over the last four quarters. Here's the math:

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[Current price per share / four full quarters of earnings per share]

In this case, the numbers are: [$532.07 / $28.12] = 18.9

Now here's where the math gets tricky. The P/E ratio can cover any period where there are four quarters of reported or estimated earnings. So when you read that Google trades for less than 13 times "forward" earnings, the equation changes to dividing current price by the consensus estimate for earnings in the year ahead. The math stays the same even if the numbers change.

Why You Should Care About This Metric

The P/E is a relative measure and as such can't tell you much without other ratios to compare with. Saying Google trades for 18.9 times earnings means little. However, saying Google trades for 18.9 times earnings while Apple's (AAPL) P/E ratio is 15.4 and Microsoft's (MSFT) is 9.9 says quite a bit. Google is more expensive, and needs to grow earnings faster in order to justify its share price.

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Motley Fool contributor Tim Beyers is a member of the Motley Fool Rule Breakers stock-picking team. He owned shares of Apple and Google at the time of publication. Check out Tim's portfolio holdings and writings, or connect with him on Google+ or Twitter, where he goes by @milehighfool.

The Motley Fool owns shares of Google, Apple, and Microsoft. Motley Fool newsletter services have recommended buying shares of Google, Apple, and Microsoft, as well as creating a bull call spread positions in Apple and Microsoft.

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