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Terms Of The Trade: Price-To-Earnings And Price-To-Earnings Growth

Terms Of The Trade: Price-To-Earnings And Price-To-Earnings Growth

Perhaps the most often cited measure of whether a company's stock is expensive, the price-to-earnings or "P/E" ratio is calculated by dividing a stock's price by its earnings per share ("EPS") over the most recent twelve months, also called the trailing twelve months or "ttm."

For example:

    If Company X shares trade at $20/share, and the EPS (ttm) is $1.25, the P/E ratio is 16 (20 divided by 1.25).

In effect, this ratio shows the number of years it will take before a share purchased will earn back its purchase price. So, in the above example, it would take 16 years for a share of Company X to earn its cost back. Also, the P/E ratio can make small and large companies more comparable, as it isn't easily affected by the number of shares (which affects other company measures such as market capitalization).

The P/E ratio, however, isn't always comparable from one company to another from a different industry or at a different stage of its growth cycle. It also doesn't account for expected future earnings growth, as it focuses on past earnings. Therefore, some investors prefer the price-to-earnings growth, or "PEG," ratio.

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The PEG ratio contrasts the cost of a share of stock to the estimated value of its future earnings based on projections of its earnings-per-share growth over the next several years.

It's calculated by dividing the P/E ratio by an estimated earnings growth rate, such as the five-year growth rate provided by Yahoo! Finance's analyst estimate pages. In the calculation, the growth rate percentage is treated as a whole number, thus:

    If Company X has a P/E ratio of 30 and its earnings are expected to grow by 25 percent in the next five years, its PEG ratio is 1.2 (30 divided by 25).

Basically, a PEG ratio below one indicates that the market may be undervaluing a company's earnings potential, while a PEG ratio above one can suggest that the market is overestimating a company's earnings power.

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