What is P/E Ratio

What is the price/earnings ratio?

The price/earnings ratio, also called the P/E ratio, is a ratio for valuing the company. To calculate the P/E ratio simply divide the stock price by the company’s earnings per share (EPS) for a specified period, such as the last 12 months. The price/earnings ratio shows how much investors will pay per share for £1 of earnings.

Using the P/E Ratio

Investors can use a company’s P/E ratio to decide whether or not to invest. When you use the market value per share in relation to earnings per share you can determine the ratio. The most common type of P/E ratio is called the trailing P/E; this is when the P/E ratio is calculated across a period of previous quarters. When the price/earnings ratio is calculated using estimated net earnings of upcoming quarters, it’s called a future P/E.

The P/E ratio indicates how much growth investors have factored into the stock price. A high ratio indicates that investors are paying much more per share than the company is earning, which is common in new businesses with a lot of earnings growth potential, like tech start-ups. Lower ratios indicate that growth has slowed, but that doesn’t necessarily mean the company is failing; in fact, a lower P/E ratio may mean the company has solidified its market share.

The P/E Ratio can help you to:

• Compare the stock prices of similar companies to find stocks that suit your investing profile
• See if the stock is undervalued, appropriately priced or overvalued.
• Decide, based on its value, if they should buy, sell or hold a particular stock.

Simply put, the P/E ratio is just a comparison of how the public feels about a company (its stock price) and how well the company is actually performing (its EPS).

Typically, stocks selling at higher P/E ratios have higher growth expectations than those selling at lower P/E ratios. Investors are generally willing to pay a higher price for current earnings because they expect future earnings to grow substantially.

Over-valued or Under-valued?

If a stock’s P/E ratio is significantly higher than those of other similar companies — or even than the company’s own historical P/E ratio — it could be due to growth prospects, but it’s also possible the stock is overvalued. If earnings have fallen, but the stock price remains the same, the P/E ratio will be higher, suggesting the company may not be as valuable as the stock price reflects.

A low P/E ratio could be well-deserved, but if a stock is selling at a relatively low P/E ratio it does not necessarily mean that it is undervalued. It may sell at a low P/E ratio because investors are wary about future earnings from the stock. The stock price may stay the same while the company’s earnings increase, which would send the P/E ratio lower and indicate poorer projected future growth. Investors may see this as an opportunity to buy the stock expecting the price will rise in the future to reflect the underlying earnings potential.

Once you’ve considered the P/E ratio and considered how it fits your investment profile, you may be ready to invest, but, as always, make sure you only do so after undertaking thorough research, including analysis of the P/E ratio.

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