GETTING STARTED Build a Strong Stock Portfolio Earnings: The Bottom Line Ten Clues to Strong Stocks Four Questions to Ask Before You Buy A Kid-Friendly Introduction to Stocks MORE... STOCK TOOLS Kiplinger's Stock Finder Test your risk tolerance What is the current yield from dividends? Which are better: income or growth stocks? Pick the Best 'Bankerage' Company

BASICS
Earnings: The Bottom Line

It all comes down to earnings. More than any other figure in a financial report, earnings -- and the prospect of higher earnings in the future -- determine whether investors will continue to bid up share prices. Earnings are the bottom line that show how much money a company can use to reinvest in business growth or to pay dividends to shareholders. To figure earnings, you subtract taxes and preferred-stock dividends from net operating profit -- the difference between revenue and operating costs. Earnings are usually summed up as earnings per share -- the company's net earnings divided by the number of common-stock shares outstanding. Earnings per share, or EPS, offers a handy way to compare past earnings to spot upward or downward trends.

Some investors measure stocks almost entirely by how much profits grow from quarter to quarter and year to year. EPS, however, only gives a starting point to evaluate stocks. It does not take into account the stock's current price. This is where the price-earnings ratio comes in. The price-earnings ratio, or P/E, is the price of a company's stock divided by its EPS. It is one of the most widely used tools in sizing up stocks. Simply put, it is how much investors are willing to pay for a dollar of the company's earnings. You may also hear it referred to as a "multiple."

When you calculate a P/E based on the past year's earnings, the P/E is called "trailing." Another way to determine a P/E is to substitute future earnings projections. This is the "forward" P/E (also referred to as the "anticipated" P/E).

When you're considering trailing P/Es, a lower ratio is often more attractive because investors may be getting a bargain. But things start to get a bit fuzzy when future projections come in to play. Without having any specifics, it could be argued that a company with a higher ratio is the better investment. A greater forward P/E means that investors regard the company more highly and expect it to have better future prospects. Perhaps, being the larger company in terms of market value, investors expect it to able to beat the competition, or the company could be on the verge of a technological breakthrough.

However, a smaller P/E means that you may get more bang for your investing buck as the company grows. And higher growth expectations lead to higher volatility: If that company doesn't produce the numbers investors expect, the market will quickly deflate its share price.

Looking ahead

How do you evaluate a company's growth? One common method is to look at the price/earnings growth ratio. The price/earnings growth, or PEG, ratio is the P/E divided by the projected earnings growth rate.

First, determine the projected growth rate using current EPS and next year's estimated EPS.

Company A's earnings are expected to grow 100% over the next year, while Company B's should grow 25%. Next, plug in the forward P/E, since the idea is to look at the company's future prospects. The PEG calculation would look like this:

A PEG ratio of 1 is considered standard -- in other words, its growth rate is already incorporated into the price of its stock. Anything higher than 1 means that the stock is trading at a premium to its growth rate. A PEG ratio lower than 1 shows that a stock may be undervalued. Company A, with a PEG of 0.21, may look like a good buy, with good potential for growth. Company B's stock price has already been bid up to incorporate its potential growth over the next year.

Putting the numbers to use

Earnings figures can be measured against entire industries or the market as a whole as well as other companies. Many stock indexes have P/Es, including Standard & Poor's 500-stock index, one of the most widely used benchmarks for blue-chip performance.

Keep an eye out for unusually high P/Es. The higher the P/E, the greater investors' expectations. The greater the expectations, the faster the stock can plummet if those expectations aren't met.

And something to keep in mind when using forward P/E and PEG ratios: These measures are dependent on analysts' projections, which can often be off the mark or flat out wrong. Don't rely solely on these numbers to pick a stock. Instead, use them as a piece of the puzzle of information necessary to determine if a company is worth your investing dollar.