If you are considering investing a company's shares, then one of the first things you'll want to know is: does the price I'm paying represent good value?
There are lots of ways to answer that question, but one of the first methods' you're likely to encounter is the price/earnings ratio – p/e ratio for short.
Many investors use the p/e ratio as a measure of whether a share is cheap or not. There's good reason for that. It's one of the simplest valuation methods out there. You simply take the share price and divide by its earnings per share (that is, its profits per share). So a company with a share price of 50p and earnings per share of 5p would have a p/e ratio of ten.
Subscribe to MoneyWeek
Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE
Sign up to Money Morning
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
A p/e ratio which is based on forecast earnings is referred to as a "forward p/e" while one based on past earnings is described as a "trailing p/e".
A p/e of ten 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, in theory, the lower the p/e the cheaper the share. However, a low p/e does not always represent good value. If investors are only willing to pay £5 for each £1 of earnings, for example, then this implies that they don't believe those earnings can be sustained.
On the other hand, companies trading on high p/e ratios might look expensive. But this might just reflect expectations of strong earnings growth. This is why fast-growing tech stocks typically trade on high p/e rations, for example. Also remember that earnings for some companies - such as housebuilders - go up and down depending on the wider economy. Such companies will tend to trade on low p/e ratios at the high points in the business cycle (when they will be making unusually high profits) and high p/e ratios at low points (when they may be loss making).
As with any valuation ratio, a p/e should not be used in isolation. But it can be a useful starting point.
For more on topics like this, subscribe to MoneyWeek magazine.
-
Farmer fury – why are rural groups protesting against Autumn Budget inheritance tax changes?Farmers are protesting against restrictions on agricultural property relief – here is how the changes affect rural communities and land investors
-
Starling announces easy-access saver paying 4% – is it a best-buy?The digital challenger bank will launch its first easy-access savings account this month, available to current account customers. Is it competitive?
-
What is a dividend yield?Videos Learn what a dividend yield is and what it can tell investors about a company's plans to return profits to its investors.
-
High earners to pay nearly £2000 more in tax due to fiscal dragVideos The government froze tax thresholds, which will drag employees into higher tax bands as wages rise with inflation. We explain what fiscal drag is, and how to avoid it.
-
What is a deficit?Videos When we talk about government spending and the public finances, we often hear the word ‘deficit’ being used. But what is a deficit, and why does it matter?
-
Too embarrassed to ask: what is moral hazard?Videos The term “moral hazard” comes from the insurance industry in the 18th century. But what does it mean today?
-
Too embarrassed to ask: what is contagion?Videos Most of us probably know what “contagion” is in a biological sense. But it also crops up in financial markets. Here's what it means.
-
Too embarrassed to ask: what is a marginal tax rate?Videos Your marginal tax rate is simply the tax rate you pay on each extra pound of income you earn. Here's how that works.
-
Too embarrassed to ask: what is stagflation?Videos Traditionally, economists and central bankers worry about inflation or recession. But there is one thing worse than both: stagflation. Here's what it is
-
Too embarrassed to ask: what is the metaverse?Videos The term “metaverse” sounds like something out of a science fiction novel (and it is). But what does it actually mean?
