Price/earnings (P/e) ratio

The price/earnings ratio is a quick way to establish a firm's relative value.

Updated August 2018

Many investors use the price/earnings (p/e) ratio as a measure of whether a share is cheap or not. There's a good reason for that it's one of the simplest valuation measures out there. You simply take the share price, and divide by the earnings (profits) per share. So a company with a share price of 50p and earnings per share (EPS) of 5p would have a p/e ratio of 10.

A p/e ratio that's based on forecast earnings is often referred to as a forward p/e ratio, while one based on past earnings is sometimes described as a trailing p/e.

P/e ratios are also sometimes referred to as multiples, as in "Acme Widgets is trading on a multiple of ten times its earnings". In effect, a p/e of 10 means you are paying £10 for each £1 of earnings, while a p/e of 20 would mean you are paying £20 per £1 of earnings. So clearly, in theory, the lower the p/e, the cheaper the share.

However, a lower p/e does not always mean that a company is good value. If investors are only willing to pay £5 for each £1 of current earnings, say, then this implies that they don't really believe current earnings levels can be sustained. Instead, there may be serious problems that will hinder future growth or lead to falling profits. Meanwhile, those trading on higher p/e ratios might look expensive but in fact, might be expected to grow exceptionally strongly (for example, high- flying tech stocks typically trade on relatively high p/es).

Also bear in mind that some industries (mining and housebuilding being good examples) are extremely cyclical. They will trade on low multiples at the high point in the economic cycle (when they are very profitable) and high p/es at low points (when they may be loss-making). The cyclically adjusted price/earnings (Cape) ratio, which averages earnings out over ten years, is one way to go about correcting for this.

See Tim Bennett's video tutorial: A beginner's guide to p/e ratios.

Recommended

Modern monetary theory (MMT)
Glossary

Modern monetary theory (MMT)

Modern Monetary theory, or MMT, has become popular on the left, both in the UK and abroad. (Wags say that it stands for "magic money tree".) 
21 Sep 2020
Price to sales ratio
Glossary

Price to sales ratio

A company's market cap divided by the company's annual sales (or revenue) gives us the price/sales ratio.
28 Aug 2020
Too embarrassed to ask: what is a p/e ratio?
Too embarrassed to ask

Too embarrassed to ask: what is a p/e ratio?

Find out how to use the price/earnings ratio (p/e ratio for short) – a useful starting place for investors looking to value a company.
26 Aug 2020
Stock split
Glossary

Stock split

A stock split increases the number of a corporation's issued shares by dividing each existing share.
21 Aug 2020

Most Popular

The Bank of England should create a "Bitpound" digital currency and take the world by storm
Bitcoin

The Bank of England should create a "Bitpound" digital currency and take the world by storm

The Bank of England could win the race to create a respectable digital currency if it moves quickly, says Matthew Lynn.
18 Oct 2020
What would negative interest rates mean for your money?
UK Economy

What would negative interest rates mean for your money?

There has been much talk of the Bank of England introducing negative interest rates. John Stepek explains why they might do that, and what it would me…
15 Oct 2020
Negative interest rates and the end of free bank accounts
Bank accounts

Negative interest rates and the end of free bank accounts

Negative interest rates are likely to mean the introduction of fees for current accounts and other banking products. But that might make the UK bankin…
19 Oct 2020