Advertisement

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.

Advertisement - Article continues below

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.

Advertisement
Advertisement

Recommended

Economic indicators
Glossary

Economic indicators

An economic indicator is any statistic that allows us to analyse how the economy is performing or is likely to perform in future.
31 Jul 2020
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".) 
14 Jul 2020
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".) 
14 Jul 2020
Barbell strategy
Glossary

Barbell strategy

A “barbell… investment strategy means weighting a portfolio towards the two extreme ends of an asset class with nothing in the middle.
8 Jul 2020

Most Popular

Eagle Lightweight GT: the reincarnation of the E-type Jag
Toys and gadgets

Eagle Lightweight GT: the reincarnation of the E-type Jag

Jaguar’s classic E-type sports car has been reinvented for the modern age. The result – the Eagle Lightweight GT – is a thing of beauty.
7 Aug 2020
Platinum: the precious metal that looks set to play catch-up with silver and gold
Silver and other precious metals

Platinum: the precious metal that looks set to play catch-up with silver and gold

Gold and silver continue to soar, but there's still time to get in. And there's another precious metal that looks set to go on a bull run too, says Jo…
7 Aug 2020
Don’t despair on dividends – these companies could be set to bring them back
Income investing

Don’t despair on dividends – these companies could be set to bring them back

The value of dividends paid out by UK stocks has plummeted this year as companies “rebase” their payment policies. But things could soon start to look…
6 Aug 2020