The stock price (per share) of a company divided by its most recent 12month earnings per share is called its pricetoearnings ratio (P/E ratio). If this P/E ratio is then divided by expected earnings growth going forward, the result is called the price/earnings to growth ratio (PEG ratio). Information available about how to determine a stock's proper ratios and use them to effectively value a stock talk about metrics like the stock's historic ratios, use them to compare industry ratios, or use them in statements like "a
This information isn't wrong, but if you need to understand and find these ratios for yourself, you'll need some extra help. Fortunately, with the aid of a simple handheld financial calculator, there is a simple mathematical approach to finding rational P/E and
Earnings Yield
The best way to understand the significance of the P/E ratio is to turn it upside down. If you divide the earnings by the price (E/P) you get the inverse of the P/E ratio, which is called the earnings yield. The earnings yield tells an investor how much return (on a pershare basis) the stock's shareholders earned over the past 12 months, based on the current share price. Remember that earnings, regardless of whether they are paid out in the form of a dividend or retained by the company for reinvestment into further growth opportunities, still belong to the shareholders. Shareholders hope that these earnings will grow going forward, but there is no way to perfectly predict what that growth will be.
Earnings Yield vs. Bond Yields
Investors have a vast array of investment options at their disposal at all times. For the purposes of this discussion, let's assume that the choice is limited to stocks or bonds. Straight bonds, whether government or corporate, pay a guaranteed fixed rate of return for some period of time, as well as a guaranteed return of the original investment at the end of that fixed period. The earnings yield on a stock is neither guaranteed nor of a definite time period; however, earnings can grow, while bond yields remain fixed. How do you compare the two? What are the key factors to consider?
Growth Rate, Predictability and FixedIncome Rates
The key factors you need to consider are: growth rate, earnings predictability and current fixedincome rates. Let's assume you have $10,000 to invest and that U.S government Treasury bonds of fiveyear maturity are yielding 4%. If you invest in these bonds, you can earn interest of $400 per year (4% of $10,000) for a cumulative return of $2,000 over five years. At the end of five years, you get your $10,000 investment back when the bond matures. The cumulative return over the fiveyear period is $20% ($2,000/$10,000).
Example  Calculating a Stock's P/E

In the example above, the P/E of XYZ rose from 33.56 to 44.64 when earnings expectations rose from 10% to 20%. What happened to the
The Real World
In real life, earnings are not perfectly predictable, so you must adjust your required earnings yield up from the guaranteed yield of bonds to compensate for that lack of predictability. The amount of that adjustment is purely subjective and fluctuates constantly as economic conditions change. In analyzing a particular stock, you need to consider how predictable that company's earnings growth has been in the past as well as possible interruptions to growth going forward.
In the example above, the price of XYZ stock is $40 per share. The reason it's trading for $40 probably revolves around uncertainties regarding the predictability of that expected earnings growth. As a result, the market, based on the cumulative subjective perspective of thousands of investors, has built in a higher return requirement. If XYZ does indeed experience 10% earnings growth over the next five years, an investor buying the stock at $40 per share will be well rewarded as the earnings stream on $10,000 (250 shares) will be $500, $550, $605, $665 and $732 for a total of $3,052, rather than $2,000. The possibility of this additional return compensates the investor for the risk that the expected earnings growth rate of 10% may not materialize.
Summing Up
Despite the subjective riskassessment variables, P/E ratios and
Over and above the fixedincome impact, P/E ratios will be higher for stocks with more predictable earnings growth and lower for stocks with less predictable earnings growth. If two stocks have comparable levels of predictability, the P/E will be higher for stocks with higher expected earnings growth and lower for stocks with lower expected earnings growth.