P/E ratio definition
The price-to-earnings or P/E ratio measures the value of a company by comparing its share price with its earnings per share. Also sometimes known as the price or earnings multiple, it is calculated by dividing the market price per share by the earnings per share.
That means it is essentially the dollar or euro or pence amount an investor can expect to invest in a company’s stock in order to receive a dollar or euro or pence of the company’s earnings. So if company X’s share price is trading at 200 pence and its earnings per share are 20 pence, then it’s price to earnings ratio or multiple is 200 divided by 20 which equals 10. That means an investor is willing to pay 10 pence for each 1 pence of earnings. A higher P/E ratio also suggests investors are expecting the company to post higher earnings growth in the future.
It is important to note that P/E ratios are just one way of valuing companies, and each has its limitations. P/E ratios are most commonly used to compare the value of one stock in a sector with another. They are also used as a guide as to whether a company is currently over - or undervalued compared with historical averages. Care needs to be taken comparing company valuations using P/E ratios between sectors as average ratios for example in the pharmaceuticals sector may be very different to those for example in the autos sector. An average P/E ratio across all sectors is about 20 to 25 times earnings.
Market analysts will also sometimes calculate a trailing P/E ratio using an average of the past four quarters’ earnings to compare historical performance, or a forward P/E ratio using average analysts’ earnings expectations for the following four quarters.