What it means
The price to earnings ratio, usually called P/E, divides the share price by the profit earned for each share over a year. A P/E of 30 sits above the average for many markets, which means investors are willing to pay a premium.
The term "P/E 30 ratio" is not a formal measure of its own but a handy way to describe a share priced at that level. Why would anyone pay 30 times earnings?
Usually because they expect profits to grow quickly, so today's earnings understate what the business will earn in a few years. Young technology and healthcare companies often trade at such multiples, while slow-growing utilities usually trade at much lower ones.
Flipping the ratio gives the earnings yield, which is 1 divided by 30, or about 3.3%. That is the profit the company earns for each dollar of share price, before any growth.
An investor accepting a 3.3% yield needs growth to make the investment worthwhile compared with safer options such as bonds. The ratio has limits.
It depends on the earnings figure used, which may be the last twelve months or a forecast, and one-off gains or losses can distort it. A very high P/E can also arise because profits are temporarily depressed, so the number should be read alongside growth, debt and cash flow.
Investors often pair it with the PEG ratio, which divides the P/E by the expected growth rate. A P/E of 30 with growth of 30% a year gives a PEG of 1, while the same P/E with growth of 10% gives a PEG of 3, which looks far more demanding.
In practice
Real-world examples.
Example
An investor screening for growth companies filters for shares with a P/E of 30 or more. The list is full of fast-growing software firms. She then checks each company's growth rate and debt before buying.
Example
A fund manager notes that a consumer brand trades at a P/E of 30 while the sector average is 18. She asks whether the brand's growth and profit margins justify a 67% premium (30 / 18 = 1.67). She decides they do not and sells.
Example
A finance director valuing his company for a share sale sees that similar listed companies trade at a P/E of 30. Applying that to his $2,000,000 of annual profit suggests a value of $60,000,000. He knows private companies are usually valued at a discount, so he expects offers well below that.
Formula
Calculation
P/E ratio = share price / earnings per share
Earnings yield = earnings per share / share price
PEG ratio = P/E ratio / expected annual earnings growth rate in per cent
A share trades at $90 and the company earned $3 per share over the last year. P/E = 90 / 3 = 30. Earnings yield = 3 / 90 = 0.0333, or 3.33%. If earnings are expected to grow 15% a year, PEG = 30 / 15 = 2.0.
Reading the result: at constant earnings it would take 30 years for the profit to add up to the purchase price. If earnings grow 15% a year, they reach about $6.03 per share in five years (3 x 1.15 to the power of 5 = 3 x 2.011), and at the same price the P/E would then be 90 / 6.03 = 14.9.Case study
Seen in the real world.
Meridian Health Devices is an illustrative, fictional company whose shares trade at $120 with earnings of $4 per share, a P/E of 30. Analysts expect earnings to grow 25% a year for the next five years because of a new product.
In the first two years, the product launch was delayed and growth was only 8%. Earnings rose to $4.67 per share, and the market cut the P/E to 22, so the share price fell to about $103 despite higher profit.
An investor who bought at $120 lost money in this illustrative story even though earnings rose. The lesson is that a high P/E leaves little room for disappointment, because both the earnings and the multiple can move against you.
Watch out
Common mistakes.
- Treating a P/E of 30 as automatically too expensive, when it may be reasonable for a company with strong growth.
- Comparing P/E ratios across industries without allowing for different growth and risk.
- Using a P/E based on earnings that include one-off gains or losses.
Questions
People also ask.
Is a P/E of 30 good or bad?
It is neither by itself, since it depends on how fast earnings are likely to grow and how risky they are.
What is the earnings yield at a P/E of 30?
It is 1 / 30, or about 3.3%.
Is P/E 30 an official benchmark?
No, it is a descriptive label or screening level that investors use, and not a rule set by any regulator.
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