You can’t open a newspaper these days without hearing about the state of our economy. Bear market this – Recession that. And left and right analysts and investors are falling all over themselves to find “cheap” penny stocks and throwing around price to earnings (P/E) ratios to make their cases. But just because a stock looks cheap doesn’t mean that it’s worth throwing money at.

The price-to-earnings ratio is one of the most well-known and maybe misunderstood metrics that investors can use to look at how much a company is worth. The P/E ratio is calculated by taking a company’s market capitalization and dividing that by its net income.

Basically, it’s a multiple that tells you how much investors are paying for that company’s net income.

But remember, P/E ratios vary from industry to industry while American Express’s P/E is somewhere around 13 right now, it doesn’t make sense to say that it’s any cheaper (or more undervalued) than Apple, which has a higher P/E of 33. They’re in different industries, so you can expect very different P/Es.

With that little nugget in mind, it’s easy to fall into the trap of thinking that P/E ratios are the end-all be-all for stock valuation. Granted, it’s a valuable tool for measuring value, but there are also some things you should keep in mind about a company’s P/E.

So, what do you need to know about P/E ratios? Well, for one, consider the fact that a stock’s market price comes into play in a big way with P/E ratios. A higher stock price means a higher P/E ratio, and vise versa.

This entry was posted on Tuesday, December 16th, 2008 at 4:57 pm and is filed under The Investment Way. You can follow any responses to this entry through the RSS 2.0 feed. Both comments and pings are currently closed.