The price-to-earnings ratio, usually written P/E, compares a company's share price with the profit it earns for each share. It answers a simple question: how many years of current profit would you pay for, if profit stayed the same? A P/E of 15 means the share costs 15 times the profit per share.
P/E is the most quoted valuation measure in the stock market, and one of the most misused. A low P/E is not automatically cheap, and a high P/E is not automatically expensive. This guide explains how to calculate it, how to read it in context, and the traps that catch people who use it alone.
The formula
P/E = share price ÷ earnings per share (EPS)
Earnings per share is the company's profit after tax, divided by the number of shares outstanding. It is also published in the company's results. Some sources use the profit of the last twelve months, which is the trailing P/E. Others use the expected profit for the coming year, which is the forward P/E. Both are useful, but they answer different questions, and they can differ a lot for a company whose profit is changing quickly.
A worked example
Suppose a company's shares trade at 60, and its earnings per share for the last year were 4.
P/E = 60 ÷ 4 = 15
You pay 15 for each 1 of annual profit per share. If the company keeps earning 4 a share and pays it all out, the earnings alone would take about 15 years to return the price. Growth changes that arithmetic, and so do dividends and the risk that the profit falls.
Now suppose the company's profit falls and its EPS drops to 2 while the share price is still 60. The P/E doubles to 30. The stock looks more expensive, and it is, relative to its current profit. The price has not moved, but the valuation has. This is the first trap: a rising P/E can mean the price went up, or that profit went down, and you need to check which.
| Case | Share price | EPS | P/E |
|---|---|---|---|
| Base year | 60 | 4 | 15 |
| Profit falls | 60 | 2 | 30 |
| Profit rises, price flat | 60 | 6 | 10 |
What a high P/E can mean
A high P/E usually tells you that investors expect profit to grow strongly in the future. A young company with fast-growing sales can have a high P/E and still be a reasonable price if the growth comes through. The high number is the market paying now for expected future profit.
A high P/E can also mean the profit is temporarily low, for example in a bad year. The P/E can look expensive exactly when the business is near a low point. This is the reason cyclical companies, such as those in mining, shipping and construction, can show a high P/E at the bottom of a cycle and a low one at the top. For those companies, a normal-year profit is a better guide than the current one.
A high P/E is also a risk. If growth does not arrive, the share can fall sharply as the expectations are cut. The higher the P/E, the more the company has to deliver to keep the price where it is.
What a low P/E can mean
A low P/E can mean good value. It can also mean the market expects profit to fall. A company whose profit is about to shrink can have a low P/E before the decline, because the market already expects the decline and prices it in. The number looks cheap, and the profit gets smaller.
The useful question is whether the low P/E is justified by the company's prospects. A low P/E backed by stable profit and a healthy balance sheet is different from a low P/E on profit that is about to fall. Look at the trend of earnings over several years, not just the latest figure.
Some sectors trade on lower P/E ratios as a matter of course. Banks, utilities and some industrial companies are often valued at lower multiples than fast-growing technology businesses. Compare a company with its own sector, not with the whole market.
The traps
Earnings can be manipulated. Companies can use accounting choices to make profit look higher or lower in a given year. One-off gains, changes in provisions or unusual items can change EPS without changing the business. Check whether the profit comes from the core business.
Cyclical earnings. For companies that move with the economy, the current P/E is misleading at the top and bottom of the cycle. Look at average earnings over a full cycle, where you can find them.
Debt. Two companies with the same P/E can have very different risk if one has far more debt. Debt can magnify the effect of a fall in profit on the share price. Check the level of borrowing alongside the ratio.
Negative earnings. If a company made a loss, the P/E is not meaningful, and many price sites show it as blank or as a dash. Do not read a missing P/E as cheap.
Share count changes. If the company has issued many new shares, EPS falls and the P/E rises for the same profit. Check the share count when you compare EPS across years.
How to use P/E well
Use P/E as a starting point, not a conclusion. Compare the company's P/E with three things: its own history over several years, the average of its sector, and the broader market. A company trading well below its own usual P/E, with profit that is stable or growing, may be worth a closer look. A company trading far above its sector, with growth that is slowing, may need a sharper reason to justify the price.
Check the quality of the earnings as well. Are they growing, and do they turn into cash? A company that reports strong profit but weak operating cash flow is worth more scrutiny. The guide on financial statements basics explains how to read the figures behind the ratio.
Finally, use P/E across a basket rather than a single company where you can. A sector or an index tells you more about the market's valuation than one company, which can be affected by a single unusual year.
Checklist
- Confirm whether the P/E is trailing or forward, and the date of the EPS used.
- Check that the profit is from the core business and not a one-off.
- Compare the P/E with the company's own five-year history and with its sector.
- Check the trend in earnings, and whether the company is cyclical.
- Look at debt and cash flow before you draw a conclusion.
Key takeaways
The P/E ratio is the share price divided by earnings per share. It tells you how much you pay for each unit of current profit, and it is the quickest way to compare what the market charges for profit across companies. A high P/E can reflect growth or temporarily low profit. A low P/E can reflect value or falling profit. Read P/E alongside the profit trend, the debt, the sector and the quality of the earnings, and it becomes a useful part of a decision rather than a verdict.
This guide is for general information, not financial advice. See the disclaimer.