The P/E ratio, made simple

What this lesson covers

• What the P/E ratio means, in plain English
• The P/E formula, and why the answer is a multiple rather than a dollar amount
• How share price and EPS connect to produce the ratio
• Where you will see P/E when researching a company
• Why a P/E can rise or fall
• Why a high or low P/E does not automatically mean good or bad
• The difference between trailing and forward P/E
• Where P/E can mislead you, and a checklist to use before relying on it

Where this sits in the series: Lesson 3 covered what a company is worth. Lesson 4 covered what it earns. This lesson puts the two together, which is what valuation actually is.

A quick recap: what EPS represents

P/E only makes sense if earnings per share is still clear in your mind, so here it is in one line. EPS takes the company's profit and expresses it on a per-share basis.

If a company earns $300 million and has 100 million ordinary shares, its EPS is $3.00.

That tells us something about the company's profitability. What it does not tell us is what investors are paying for those earnings. EPS is the earnings side of the story. P/E is the bridge between those earnings and the market price of the share.

What the P/E ratio tells us

In plain English, the P/E ratio tells us how much investors are paying for each dollar of current earnings.

Take a company with a share price of $60 and EPS of $3.00. Divide $60 by $3 and you get 20.

A P/E of 20 means the market price of the share is twenty times the company's annual earnings per share. Put another way, investors are currently paying $20 in share price for each $1 of annual earnings represented by that share.

One thing to be careful about. A P/E of 20 does not mean the company will take exactly twenty years to repay your investment. It is a valuation multiple, not a guaranteed payback period. It simply gives us a way to relate price to earnings.

Worked example: calculating P/E

Three steps, in order.

Try another one yourself before reading on. If the share price is $80 and EPS is $4.00, what is the P/E? The answer is 20 again — the same multiple, arrived at from different numbers.

Notice that P/E is not a dollar value. It is a multiple. That is why you will usually see it written as 20 times, 25 times, 30 times, and so on.

Is a high P/E good or bad?

Neither, by itself. This is where beginners most often get caught — seeing a high P/E and reading it as expensive, therefore bad, or a low P/E as cheap, therefore good. It is not that simple.

A high P/E often reflects expectations of strong growth: a recognised brand, a competitive advantage, capable management, a long runway ahead. But if the company later grows more slowly than expected, the share price can fall even though the company is still profitable.

A low P/E can point to value. It can equally be a warning — falling sales, debt, competition, regulation, or a weak outlook. The key lesson is that P/E must always be interpreted in context.

Compare like with like

P/E becomes far more useful when you compare similar companies. Here are two with exactly the same share price.

The share prices are identical, but the valuations are not, because the earnings differ. Investors are paying twice the earnings multiple for Company B.

Why might they do that? Perhaps Company B is expected to grow much faster. Perhaps its margins are improving. Perhaps investors believe its future earnings will rise sharply. Or perhaps it is simply overvalued. P/E alone cannot answer that, which is why a higher P/E does not automatically make Company A the better value.

Comparison works best inside the same industry, or among companies with similar business models. Comparing a fast-growing software company with a regulated utility will not tell you very much.

Trailing P/E and forward P/E

Financial websites often show more than one P/E figure. Two versions are common.

If a company is expected to increase EPS strongly next year, its forward P/E may look much lower than its trailing P/E, which makes the shares appear cheaper on future earnings. That only holds if those earnings actually arrive.

The beginner rule: always check which P/E you are looking at before you compare two companies.

When P/E can mislead us

P/E is useful, and it has real limitations. Five worth knowing.

• If a company is making a loss, EPS may be negative and the P/E is usually not meaningful. You may see a blank value, N/A, or no P/E at all.
• Different industries naturally trade at different valuation levels, so a P/E that looks high in one may be perfectly normal in another.
• One-off items distort EPS. A large asset sale, a restructuring cost or an unusual accounting item can temporarily lift or reduce earnings, and the P/E moves with it.
• Cyclical companies are tricky. Near the top of a cycle, profits are unusually high and the P/E can look very low — exactly when earnings may be close to a peak. When profits collapse, the P/E can look high even though the share price has already fallen.
• P/E says nothing directly about debt, cash flow, balance-sheet strength, competitive advantage or management quality.

Which is the general point: never rely on one ratio alone.

A simple beginner checklist

Six questions to run through whenever you see a P/E ratio.

• Is the company profitable? If earnings are negative, P/E may not be useful at all.
• Am I using trailing or forward P/E? Make sure you know which earnings are being used.
• How does it compare with similar companies? Same industry, similar business model.
• What growth is the market expecting? A high P/E may only make sense if earnings can grow enough to justify it.
• Are the earnings stable and sustainable? Or were they boosted by something unusual?
• What else should I check? Revenue growth, profit margins, free cash flow, debt, return on equity, and other valuation measures.

The point is not to make analysis complicated. It is to avoid making a decision from a single number.

The three ideas to carry forward

A P/E of 15, 20, 30 or 50 is not automatically good or bad. It depends on the company's growth, its industry, the quality of its earnings, the risks it carries, and what investors are already expecting. The most useful way to think about P/E is as a starting point for valuation — not the final answer.

One more connection worth holding on to, because it explains why the number moves. Share prices change every trading day. So if the price stays the same but EPS rises, the P/E falls. If the price rises faster than EPS, the P/E rises. The ratio can move even when the company has reported nothing new.

Where to go next

If you'd like to see these ideas applied to real companies and real results, How Markets Think is where I write that up each week — earnings, deals and market moves, explained in plain English.