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Lesson 12. Evaluating Stocks > The Price/Earnings Ratio - Pg. 68

Evaluating Stocks 68 The Forward P/E Ratio The forward P/E ratio uses the dividends of the previous two quarters and the projected earnings for the next two quarters. For example, if you were determining the P/E ratio on January 1, 2000, you would add the total of the dividends paid in the final two quarters of 1999 and then add what the company believed it would be paying out in the first two quarters of 2000. The projected earnings are used to give a better idea of how the stock's P/E ratio is expected to perform. The use of the trailing two quarters keeps the forward P/E ratio reasonable. A company is going to have a hard time convincing investors that the stock will pay $10 in dividends in the next two quarters if the last two quarters showed dividends of only $1 per share. However, since no one can predict for certain how the stock really will do, the forward P/E ratio gives the least accurate picture of the stock. Interpreting the P/E Ratio Now that you know the parts that determine the P/E ratio, what does it measure in real terms? Think of it this way: Say you want to buy a store. You find both a clothing store and a convenience store for sale. To buy the clothing store will cost you $1,000, and you know that the store generates $100 in profits per year. The convenience store will cost you $2,000 but will generate $250 per year in profit. The clothing store will generate $1 in profit for every $10 of your investment. The convenience store, however, will make $1 for every $8 you put into it (1,000 ÷ 100 = 10:1 versus 2,500 ÷ 200 = 8:1). While the convenience store is more expensive, it is obviously a better investment. Stocks work on the same principle in that a P/E ratio doesn't concern itself with how much or how little a stock costs, but rather with what kind of return you can expect for the investment--in other words, how much bang-for-your-buck potential. Tip Since the P/E ratio is a fraction of the price of the stock, investors refer to a P/E ratio as