| The PE ratio is one of the most widely watched measures of valuation for both the
stock market as a whole and individual stocks. Many people use it to determine whether the
market (or a given stock) is "expensive" or "cheap". The calculation
is very simple. You simply divide the price by the yearly earnings. One easy
way to think of it is the P/E ratio is really just equal is the
price divided by earnings... so:
P/E ratio = Price/Earnings
For instance, on
10/01/01 the SP500's closing price was 1038.55. Its cumulative earnings for the 500
companies in the index are $36.79. So the P/E ratio is calculated as 1038.55 /
36.79 = 28.23.
This means that if you are investing in the SP500 via a stock index fund, you are
paying $28.27 for each dollar of earnings that those 500 companies will have this year.
The
PE ratio does not work very well as a timing device, but it can give you some idea of the
whether the market is "cheap" or "expensive". And as you can see from
the above chart, it is definitely not cheap right now, even after the large
losses that the market has suffered.
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