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.