by James Copenhaven

Chances are you've heard the term price/earnings ratio (P/E ratio). When it comes to valuing stocks, the price/earnings ratio is one of the oldest and most frequently used ratios.
 
P/E is short for the ratio of a company's share price to its earnings per-share (EPS).  Most of the time, the P/E is calculated using EPS from the last four quarters. This is also known as the trailing P/E. However, occasionally the EPS figure comes from estimated earnings expected over the next four quarters. This is known as the leading or projected P/E.
 
 
Theoretically, a stock's P/E tells us how much investors are willing to pay per dollar of earnings. For this reason it's also called the "multiple" of a stock. In other words, a P/E ratio of 20 suggests that investors in the stock are willing to pay $20 for every $1 of earnings that the company generates.
 
Although the EPS figure in the P/E is usually based on earnings from the last four quarters, the P/E is more than a measure of a company's past performance. It also takes into account expectations for a company's growth.  Remember, stock prices reflect what investors think a company will be worth.  Future growth is already accounted for in the stock price. As a result, a better way of interpreting the P/E ratio is as a reflection of the market's optimism concerning a company's growth prospects.
 
If a company has a P/E higher than the market or industry average, this means that the market is expecting big things over the next few months or years. A company with a high P/E ratio will eventually have to live up to the high rating by substantially increasing its earnings, or the stock price will need to drop.
 
The P/E ratio is a much better indicator of the value of a stock than the market price alone. For example, all things being equal, a $10 stock with a P/E of 75 is much more "expensive" than a $100 stock with a P/E of 20.
 
The P/E ratio can be useful when comparing one company to another in the same industrial, but be careful since it is only one statistic and depending on the accuracy of the expectations of earnings the value can be misleading.
 
Source: Investopedia.com