What you need to know about the p/e ratio

Simple to calculate and widely quoted, the price to earnings (p/e) ratio is still the king of ratios when it comes to share investing. But like most simple things, the p/e ratio can be misleading if used incorrectly. Tim Bennett explains what you should watch out for when working out the p/e ratio, and what it really tells you.

Simple to calculate and widely quoted, when it comes to share investing, the price to earnings ratio (PER) is still the king of ratios. The dotcom years of the late 1990s spawned a few pretenders designed to put a value on the era's many loss-making tech stocks EV/ebitda, for example but none have had the same staying power.

However, no ratio is perfect and like most simple things the p/e ratio can be misleading if used incorrectly. So, what should you watch out for when working it out, and what does it really tell you?

How to work out the p/e ratio

The starting point is the 'current' p/e ratio; either divide the latest share price by earnings per share (EPS, at the foot of the profit and loss account), or the market capitalisation (number of ordinary shares multiplied by the share price) by net profit. So, if the current share price is £10 and EPS is £1, the p/e ratio is ten.

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However, that isn't all there is to it. The above p/e ratio is a historic measure. It tells you how long it would take to make back your initial investment in the company if it keeps generating the same earnings that it did in the past year (in this case, ten years) but there's certainly no guarantee that this will happen.

This is why analysts' reports and websites usually quote two p/e ratios the one described above and a 'forward' p/e ratio, which uses the current share price, but this time divided by an estimated figure for next year's earnings. This is particularly useful when last year's profits were distorted by a one-off event, such as a large asset sale or writedown.

The forward p/e ratio is also helpful when a company is emerging from a period of losses (since dividing a share price of £10, for example, by a 'current' EPS number of -£2 gives a meaningless result of -5). So you can take a look at what analysts are expecting for the year ahead in terms of profits, and use that figure instead.

How to use the p/e ratio

So you know what the p/e ratio is but what does it tell you? Concluding that a company is a bargain on a PER of ten, with no comparative, is as meaningless as saying that a car costing £10,000 is cheap. Even if the average car costs less, £10,000 would be a bargain for a Porsche, but something of a rip-off for a second-hand Fiat Panda. So what should a company's p/e ratio be compared with?

The market

Starting from the top, the p/e ratio can be a useful guide to the value of market as a whole. It's a straightforward enough figure to find either in the pages of the Financial Times or on a site such as Digital Look.

Say you're looking at a FTSE 100 stock such as Royal Dutch Shell. You might take the p/e ratio of the market overall, and compare it to the p/e of the individual stock. Say the FTSE 100 is on a p/e of 14, and Royal Dutch Shell is on a p/e of ten. You might conclude that Shell is cheap relative to the rest of the market.

But that's a bit simplistic. After all, the FTSE 100 contains everything from banks to oil majors to pharmaceutical groups, all of which are subject to different economic pressures and risks.

The sector

So a better bet might be to compare the company to its peers.

Let's say the oil sector as a whole is on a p/e of 12. Again, Shell (on a p/e of ten) would look cheap on this basis - it's trading at a 'discount' to the sector. So is there a companyspecific reason for this? Does it deserve to trade on a discount for some reason? Or is it a bargain?

Indeed you might also wonder in this example, why is the whole oil sector trading at a discount to the wider FTSE 100? Is it because analysts believe the high oil price to be unsustainable?

If this was the case, then oil company earnings would likely be heading for a fall, and so would deserve a lower rating than the wider market.If you, on the other hand, believe the oil price will stay high, then the sector could be offering good value.

The company

Another useful tool in considering whether a stock is cheap is to look at how the market has valued it in the past. For most stocks, Morningstar gives a five-year p/e ratio that, once averaged, can make a useful benchmark. If a stock is trading at below its five-year p/e ratio, then that shows that the market is placing a lower value on it than it has in the past.

That doesn't mean there isn't a good reason for that, of course but it's a useful starting point when looking for potential bargains.

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.