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.
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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.
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