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

Margin call
Glossary

Margin call

When an investor borrows to bet on markets, they put down a deposit known as “margin”.
2 Apr 2021
Resource curse
Glossary

Resource curse

The term “resource curse” refers to the observation that countries with abundant natural resources also tend to be less economically developed than th…
14 Jan 2021
Balance of payments
Glossary

Balance of payments

The balance of payments refers to the accounts that sum up a country's financial position relative to other countries.
8 Jan 2021
Yield-curve control
Glossary

Yield-curve control

Yield-curve control is when a central bank aims to control long-term interest rates by pledging to buy (or sell) as many long-term bonds as needed to …
25 Dec 2020

Most Popular

The bitcoin bubble will burst: here’s how to play it
Bitcoin

The bitcoin bubble will burst: here’s how to play it

The cryptocurrency’s price has soared far beyond its fundamentals, says Matthew Partridge. Here, he looks at how to short bitcoin.
12 Apr 2021
Four investment trusts for income investors to buy now
Investment trusts

Four investment trusts for income investors to buy now

Some high-yielding listed lending funds have come through the crisis with flying colours. David Stevenson picks four of the best.
12 Apr 2021
Central banks are rushing to build digital currencies. What are they, and what do they mean for you?
Bitcoin

Central banks are rushing to build digital currencies. What are they, and what do they mean for you?

As bitcoin continues to soar in value, many of the world’s central banks are looking to emulate it by issuing their own digital currencies. But centra…
8 Apr 2021