Price to Earnings Ratio
In this video, we look at what P/E Ratio is and how to calculate it.
What is a P/E ratio?
The price to earnings (P/E) ratio tells you how much investors are willing to pay for every pound of profit a company delivers. Generally, the higher the number the more valuable the market thinks the company is.
Earnings per share
To understand the P/E ratio, it helps to understand earnings per share (EPS). You calculate EPS by taking a company’s profit and dividing it by the number of shares available.
It used to indicate how profitable a company is. Generally, higher earnings per share (EPS) could mean a company has the potential for higher profitability.
It’s normal to see adjusted earnings per share (EPS) reported on a company’s accounts. It takes different factors into consideration, including inflation.
How do you calculate a P/E Ratio?
The P/E ratio measures a company's share price against its earnings per share.
It's done by taking the share price and dividing it by the earnings per share, like so:
What does the P/E Ratio mean?
Some investors use the P/E ratio to indicate how profitable a company is. It could be part of the ''fundamental'' analysis done to look at a company’s future.
One way to use P/E ratios is to compare a company’s current P/E ratio to its long-term average. If shares change hands significantly above the long-term average, it tells you the market has high hopes for the company. This can sometimes cause volatility if the company doesn’t deliver on investors’ expectations.
It can also make sense to use the P/E ratio to compare similar companies within the same industry. Comparing an energy stock to tech shares won’t tell you much about how the market rates it. But comparing two energy stocks will tell you which company could offer better value.
Take the below example.
| Company A | Company B | |
|---|---|---|
| Share price (£) | 1.50 | 2.50 |
| Earnings per share (£) | 0.10 | 0.25 |
| P/E ratio | 15 | 10 |
Even though Company B’s shares are more expensive, they’re better value. You’re paying less for each pound of profits.
It can sometimes be used to understand how the market feels about a company.
How can I use the P/E ratio?
On its own, the P/E ratio doesn’t give the whole picture of a company and its potential. Companies that are new and don’t report a profit pose a problem for P/E ratios. This is just one example.
It might also be worth thinking about the sectors as well. Valuations, cash flows, and growth timelines can vary drastically across different sectors.
There are a few other factors that affect the P/E ratio too. The earnings that a company report is just one of these. Reported earnings are an essential part of this calculation. This is also one of the figures that a company can easily manipulate.
Ultimately, you can still use the P/E ratio to compare two companies within the same sector. Like most measures, it’s best used with context and other figures that give you a fuller picture.
Related topics
Read more related glossary terms
Funds
A fund is a collective investment that pools together money from lots of individual investors. Learn more about the different types of mutual funds and how they work here.
Shares
Shares represent part-ownership of a company. As a shareholder you own a ‘share’ of the business, and the monetary value attached to it, which can be sold to other investors.