Making sense of a stock's 'P/E ratio'

Q: The P/E earnings (ratio) has always confused me. Isn't the number an inverted fraction? If XYZ company's stocks sell for $1 and it earned $0.05 ,the price to earnings is 20 (1.00/.05) -- instead of a more friendly representation like 5 percent (.05/1.00 * 100). I would think it would be easier to understand if XYZ told its investors their stock value earned 5 percent. Please correct me if I'm wrong. — Jim C., Las Vegas

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A: You could calculate it that way, but looking at the price paid for every penny of earnings is more like putting a “price tag” on each stock. To the extent that stocks trade on earnings, keeping the price in the numerator more accurately reflects prices paid. So the higher the P/E, the more you’re paying for the stock. (Inverting it would reverse this comparison.)

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The percentage measure is usually reserved for ratios like Return on Equity or Return on Investment. That’s given as a percentage because it more like the return you get on a fixed income security or the dividend return on a stock.

About the only place you typically see a percentage given as a price is when you’re talking about bonds. When Treasury bonds are first issued, investors bid on them by naming the minimum interest rate they’ll accept before they’ll part with their money, lending it to the government. As those bonds are traded in the secondary market, the yield moves up and down depending on how much payback new investors want for their money.