Stock analysts and investors use a number of different ratios to compare stocks to each other and over time. The ratios can indicate whether or not a particular stock is undervalued, overvalued or priced appropriately. Depending on the comparison of the ratio to competitors and with the past price of the stock, analysts and investors can get a sense of how much the stock is worth. Two of the most popular and important ratios for this analysis are the forward price/earnings ratio and the return on equity.
The Forward Price/Earnings Ratio
The forward price/earnings (P/E) is simply the multiple of the company's current price per share divided by the estimated per-share earnings for the company for the next four quarters. The ratio indicates how many times over investors are paying for one year's worth of the company's earnings.
How to Use the Forward P/E Ratio
By itself, the forward P/E ratio is not very useful. It needs to be compared to how the company's shares have traded in relation to its earnings in the past; you also need to see how the company's P/E compares to competitors' P/Es. All else being equal, a lower forward P/E ratio means you can purchase the company's earnings for less. However, companies with greater growth prospects will naturally trade at a higher forward P/E because their earnings are expected to grow rapidly, so further analysis is needed to ascertain whether or not the shares are overvalued or undervalued.
Return on Equity
Return on equity is the ratio of the company's earnings over a period of time to the average amount of equity invested in the company during that time. Invested equity can come from selling shares to investors or retaining earnings generated in the past. It's an important measure to determine whether the company is generating enough earnings to justify the equity invested.
How to Use Return on Equity
As with the forward P/E, the ROE needs to be compared to the historical record and to competitors' ROE. All else being equal, the greater the ROE, the better things will be for those who have invested in the company. The ROE can be unsustainably high if a company does not retain earnings for reinvestment in the business or if other companies or entrepreneurs seek to duplicate the elevated ROEs by competing with the company. It can also be elevated by companies using debt rather than equity for investment, which can be risky.
Forward P/E vs. ROE
The forward P/E is useful for making decisions on the current valuation of a company and for determining whether the shares are currently trading for a fair price. The ROE is useful for determining whether the company is generating enough earnings to justify all the equity invested compared to what it has done in the past and compared to the competition. Both tools are an integral part of the analysis of a company's shares.
Alan Rambaldini has been writing about investing and the financial markets since 2007. He has written about the insurance industry and the Exchange Traded Fund market for Morningstar.com and Morningstar.co.uk. Rambaldini holds a Masters of Business Administration from the University of Notre Dame.