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P/E ratio definition
P/E ratio is an important metric used to assess the relative value of a stock (or sometimes an index or industry). It is calculated as its share price divided by earnings per share (EPS).
P/E ratio is also often referred to price to earnings, PE ratio or price-earnings multiple.
Using P/E ratios
If Lloyds Banking Group’s share price is 100p and its EPS is £0.04 then its P/E is 25 (100/4=25).
By dividing a company’s current share price by its earnings per share, traders are able to assess the level at which shares are trading compared to the profit a company is making. If a company has a high P/E ratio, then those buying its shares are usually anticipating that earnings will increase in the future to justify its valuation. It may also indicate that the company is currently overvalued.
Types of P/E
P/E ratios are usually calculated using 12-month trailing EPS. It is possible, however, to use projected earnings to create a forward P/E ratio. Many analysts will also create normalised P/E by taking a company’s normalised earnings.
Different industries will have different average P/E ratios, so the definition of a high P/E varies between assets. Growth companies will tend to trade with higher P/E ratios than established blue chip stocks.
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