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.
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.
-
What is the 25x retirement rule and does it work?The 25x retirement rule has been around for decades but many experts question if it is a suitable strategy
-
When is the self-assessment tax return deadline?If you are self-employed, rent out a property or earn income from savings or investments, you may need to complete a self-assessment tax return. We run through the deadlines you need to know about
-
Halifax: House price slump continues as prices slide for the sixth consecutive monthUK house prices fell again in September as buyers returned, but the slowdown was not as fast as anticipated, latest Halifax data shows. Where are house prices falling the most?
-
Rents hit a record high - but is the opportunity for buy-to-let investors still strong?UK rent prices have hit a record high with the average hitting over £1,200 a month says Rightmove. Are there still opportunities in buy-to-let?
-
Pension savers turn to gold investmentsInvestors are racing to buy gold to protect their pensions from a stock market correction and high inflation, experts say
-
Where to find the best returns from student accommodationStudent accommodation can be a lucrative investment if you know where to look.
-
The world’s best bargain stocksSearching for bargain stocks with Alec Cutler of the Orbis Global Balanced Fund, who tells Andrew Van Sickle which sectors are being overlooked.
-
Revealed: the cheapest cities to own a home in BritainNew research reveals the cheapest cities to own a home, taking account of mortgage payments, utility bills and council tax
-
UK recession: How to protect your portfolioAs the UK recession is confirmed, we look at ways to protect your wealth.
-
Buy-to-let returns fall 59% amid higher mortgage ratesBuy-to-let returns are slumping as the cost of borrowing spirals.
