A:

The price-to-earnings (P/E) ratio is one of the most frequently used and trusted stock valuation metrics. It is calculated by dividing a company's share price by its earnings per share. This provides a measure of the price being paid for the earnings. A high P/E ratio signifies greater investor confidence in a company's future prospects, but it can also be a sign shares are overvalued.

A company's P/E alone doesn't give a full picture of how expensive a stock is. It is important to look at it relative to the company's industry or a broad market index such as the S&P 500 or Dow Jones Industrial Average (DJIA).

 

S&P 500 P/E Ratio and Dow Jones P/E Ratio

Many financial websites have P/Es for individual companies, but not for indexes like the Dow or S&P 500. And while some websites do contain P/E ratios for indexes, the accurate P/E ratio of an index, which is the index's total price divided by its total earnings, can sometimes be difficult to obtain. Some calculations or listings of an index's P/E ratio do not include companies in the index that have negative earnings, or they fail to factor in the weighting of the index. Typically, to get an accurate P/E reading, analysts and investors need to go to the index publisher's website.

The most accurate P/E ratio for an index will be found if an investor calculates the P/E ratios of all equities that make up the index. Since that can be a time-consuming process, some investors prefer to accept the approximation provided by the P/E ratio of an exchange-traded fund (ETF) that closely tracks the index in question. While this measure is not as exact as the index's own measure, the information is a lot easier to find. For example, those who want to know the P/E ratio of the S&P 500 can look at the SPDR S&P 500 ETF (SPY), and for the Dow, investors can consult the SPDR Dow Jones Industrial Average ETF (DIA).

There is likely to be some discrepancy between an ETF's P/E ratio and that of the index itself. This discrepancy is due to the fees charged on an ETF, along with the fact that ETFs are traded on the stock market. Fluctuations in the price of the ETF are affected by both the underlying index and the regular price movement of the ETF, which acts like a stock. Further variation can result from the fact that the ETF's holdings may not precisely match the index's equity makeup. That said, the return on an ETF is often very close to that of the index, and an ETF's P/E ratio often provides a good approximation for the P/E of the index it tracks.

For further reading, see Understanding the P/E Ratio and Introduction to Exchange-Traded Funds.

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