This article is from the How to Start an Investment Program tutorial, author unknown.
Better known as the "P/E," this ratio between the stock price and the earnings of the company is a useful measure of whether a stock is underpriced, overpriced, or fairly priced. The way a P/E number is derived is by taking the current price of the stock and dividing it by the company's earnings for the past 12 months or fiscal year. If, for example, Dentsply stock was trading at a price of $25 a share and the company's earnings for the prior 12 months were $2.50 a share, the P/E ratio would be 10. This number (10) can be thought of as the number of years it will take the company to earn back the amount of your initial investment.
It is also useful when making a comparison with other like companies or the industry norms.
For example, if a company similar to Dentsply had a P/E of 12, the P/E ratio would suggest that Dentsply is the better buy. Or, if you find that the P/E average for the 50 companies that make up the Medical-Dental Equipment and Supplies industry is 18 and Dentsply is at 10, this is another encouraging sign. In most instances, the lower the P/E value the better.
Conversely, try to avoid stocks with an excessively high P/E. This does not apply, however, to all stocks and especially those that are valued for some other underlying reason besides earnings. Large cap stocks, such as those that make up the Dow 30, can be valued for reasons such as their dividend payout, or capital assets they own such as real estate holdings. The P/E would surely not tell the whole story.