When doing your research on what stocks to invest in, you will undoubtedly hear analysts and financial pundits mention something called a P/E, or price-to-earnings, ratio. This is one of the key numbers in a stock table, and one you’d be wise to brush up on. Let’s review what the P/E ratio shows, how investors use it to evaluate a stock, and some guidelines to make the most of it.

Written by Damian Davila (WiseBread.com)

What is the P/E ratio?

It’s the ratio of a stock’s market value per share to its earnings per share (EPS). Generally, the EPS is from the last trailing 12 months (TTM). However, some financial analysts may use an EPS figure from a shorter trailing period, such as one or two quarters, or a future period, such as over the next six to 12 months.

This is why it’s important to pay attention to whether a P/E ratio calculation is using historical or projected numbers. Estimated numbers are subject to a margin of error and will be updated as new data becomes available.

A P/E ratio tells you how much investors are willing to pay to receive $1 in return for investing in a stock. Historical data suggests that on average, investors are willing to pay $15 for every dollar of earnings (a P/E ratio of 15). However, P/E ratios can vary across industries and particular companies. On March 10, 2017, the P/E ratios of Facebook Inc. [Nasdaq: FB], McDonald’s Corporation [NYSE: MCD], and Toyota Motor Corp. [NYSE: TM] were 39.95, 23.36, and 10.70, respectively.

How investors interpret the P/E ratio

The main appeal of the price-to-earnings ratio is that it provides a single, standardized metric to an investor evaluating whether or not a stock is worth buying (or selling). However, any P/E ratio is open to a lot of interpretation.

High P/E ratio

On one hand, a high P/E ratio could indicate that investors are expecting a company to grow its future earnings. On the other, it could be a signal of “irrational exuberance” — a term coined by former Fed chairman Alan Greenspan to refer to unsustainable investor enthusiasm…