What the P/E ratio tells you
The P/E ratio sets a market price against an accounting figure. The share price is what buyers and sellers are paying for one share, and it changes every trading day. Earnings per share comes from the company’s reported results, or from a forecast, and changes only when new figures are published.
A P/E of 20.0 means the share price is 20 times one year’s earnings per share. Turned the other way up, earnings are 5% of the share price, a figure known as the earnings yield. A higher P/E means investors are paying more for each unit of current earnings.
Trailing and forward P/E
Trailing P/E uses reported earnings for the past twelve months, so the figure is known but looks backward. Forward P/E uses forecast earnings, usually for the next twelve months or the next financial year, so it rests on expectations that may turn out to be wrong. The two can differ widely for a company whose earnings are changing quickly. Use the same kind of earnings for every company you compare, and note which one you used.
Reading a high or low result
The ratio reflects what the market expects, not only what the company has earned.
- A high P/E can mean investors expect earnings to grow. It can also mean current earnings are temporarily low, for example after a one-off charge, which pushes the ratio up even if the price has not moved.
- A low P/E can mean investors expect slower growth or see more risk. It can also follow a year of unusually high earnings that are not expected to last. A low P/E is not, on its own, evidence that a share is undervalued.
What is typical varies by industry and changes with market conditions, so compare a company with its own history and with similar companies measured the same way.
When P/E is not meaningful
P/E needs positive earnings. When EPS is zero the ratio cannot be calculated. When EPS is negative, the result would be a negative number that looks lower than the P/E of any profitable company, which has no sensible reading. In both cases the calculator shows a message instead of a result. Very small positive earnings cause a related problem: the ratio becomes very large and says little about the company.
What P/E does not show
- It ignores debt. Two companies with the same P/E can carry very different amounts of borrowing.
- It depends on accounting earnings, which can include one-off items and reflect choices such as depreciation methods.
- It does not tell you whether earnings will grow, only what the market is paying for them now.
Common mistakes
- Mixing trailing P/E for one company with forward P/E for another.
- Using basic EPS for one company and diluted EPS for another.
- Taking the share price and EPS in different currencies, or for different classes of shares.
- Dividing by a single quarter’s EPS instead of a full year’s, which makes the ratio roughly four times too high.
Related measures
Earnings per share explains the denominator, including how preferred dividends and changes in the share count affect it. The price-to-book ratio compares the same share price with equity per share instead of earnings. EV/EBITDA values the whole business, debt included, so it is less affected by how a company is financed. All market-based measures are listed under valuation ratios.