What it means
Earnings per share, or EPS, is the company's profit after tax divided by the number of shares in issue. The P/E ratio then compares the share price with that figure.
A ratio of 15 means investors pay $15 for each $1 of annual earnings. A high P/E usually signals that the market expects strong future growth, or sees the company as low risk.
A low P/E can mean the shares are undervalued, or that investors expect profits to fall. Neither reading is automatic, which is why the ratio is a starting point for questions rather than a final answer.
There are two common versions. The trailing P/E uses earnings from the last twelve months, which are known facts, while the forward P/E uses analysts' forecasts for the coming year.
Forward figures are more relevant for valuation but depend on forecasts that may prove wrong. Business leaders use P/E in several ways, from judging the value of their own company's shares to estimating what an acquisition target might cost.
If a competitor trades at 18 times earnings and has profit of $5,000,000, a rough valuation is $90,000,000. Private company valuations often borrow public company multiples, adjusted for size and liquidity.
The ratio has limits. It ignores debt, can be distorted by one-off gains or losses, and means nothing when earnings are negative.
For that reason analysts pair it with other measures such as enterprise value to EBITDA and price to cash flow. The ratio also links to interest rates and risk.
When interest rates are low, investors tend to accept higher P/E ratios because safe alternatives pay little, and when rates rise the same shares often trade at lower multiples.
In practice
Real-world examples
Example 1
A fund manager compares three supermarket chains trading at 12, 14 and 22 times earnings. She investigates the 22 times company and finds it is growing faster through online sales, which partly explains the premium.
Example 2
A founder preparing to sell her software company notes that listed peers trade around 20 times earnings. With profit of $3,000,000, she uses $60,000,000 as an opening reference point, then adjusts down because her business is much smaller.
Example 3
A finance director sets a share buyback programme and tracks the company's P/E over time. When the ratio falls to 9, well below its five-year average, the board approves a larger repurchase. The finance director records the reasoning in the minutes, noting that the decision depends on earnings holding steady and that the plan will be paused if profit forecasts are cut.
Think of it
P/E shows how expensive a stock is relative to profits-valuation multiple.
Formula
Calculation
P/E ratio = share price / earnings per share, where EPS = net income / shares in issue
Suppose a company earns net income of $20,000,000 and has 5,000,000 shares in issue. EPS is 20,000,000 / 5,000,000 = $4.00. The shares trade at $60, so the P/E ratio is 60 / 4 = 15. The earnings yield, the inverse measure, is 4 / 60 = 6.67%. If profit rose 10% to $22,000,000 with the price unchanged, EPS would be $4.40 and the P/E would fall to 60 / 4.40 = 13.6.Case study
Seen in the real world
Fernhollow Beverages is an illustrative, fictional drinks company whose shares traded at $48 with earnings per share of $3.00, a P/E of 16. In the following year the company sold a warehouse and booked a one-off gain, lifting EPS to $4.50 and cutting the P/E to 10.7.
Some investors read the lower ratio as a sign the shares had become cheap. The finance director explained that $1.50 of the EPS came from the property sale and would not repeat. Excluding it, underlying EPS was still $3.00 and the P/E was still 16, and the illustrative lesson is to adjust for one-off items before drawing conclusions.
The board used the underlying figure when presenting to investors, and set out the one-off gain separately in the announcement. Analysts valued the shares on the steady figure, and the illustrative share price held close to its earlier level.
Watch out
Common mistakes
- Comparing P/E ratios across very different industries, when growth and risk differ widely between sectors.
- Reading a low P/E as a guaranteed bargain, when it may reflect expected profit declines.
- Ignoring one-off gains and losses that distort the earnings figure in the denominator.
Questions
People also ask
What is a good P/E ratio?
There is no universal number, since it depends on the industry, growth and interest rates, so compare with peers and the company's own history.
What does a negative P/E mean?
When a company makes a loss the ratio is not meaningful, and it is usually shown as not applicable.
What is the difference between trailing and forward P/E?
Trailing uses past reported earnings, and forward uses forecast earnings for the next period.
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