Price/earnings ratio: meaning and how to calculate

The price/earnings ratio (or P/E ratio as it’s also called) is a widely used shorthand for assessing a company’s valuation. It measures how much investors are paying for each unit of earnings. If it’s high, they may be paying too much and if it’s low, they’re getting those earnings more cheaply. While it can be a useful tool in highlighting opportunities and avoiding mistakes, it needs to be employed with care.

The P/E ratio formula is the current share price divided by the last 12 months’ earnings per share. The result will be a multiple – 10x, 20x and so on. The theory is that the lower the ratio, the more attractive the shares: the investor with low P/E stocks is getting more earnings for the price they’re paying. Where the P/E ratio is very high, it implies significant optimism about a company’s future prospects. This has been particularly evident in some of the technology stocks in recent years, which have reached P/E ratios of 150x or higher. 

Price/earnings ratio is a quick and easy way to judge a company’s valuation relative to the wider market, its own history and its peer group. However, it is a point in time measurement and that can be deceptive for several reasons. Companies may have short-term problems that depress their earnings – a problem in a factory, a temporary disruption to demand – but it doesn’t necessarily mean that the stock is expensive. The reverse is also true, a short-term blip in earnings can make a company look attractive, but it may not be able to sustain those earnings. The pandemic threw up lots of examples of this, where there was high, short-term demand for certain products and services.

Equally, the P/E ratio doesn’t accommodate expectations of future growth. The P/E ratio of a fast-growing technology company may look very high, but if the earnings are growing even faster, it may be a bargain. Equally, a company may have a low P/E ratio but could be seeing declining sales and falling profitability. That makes it a value trap rather than an obvious buying opportunity. The P/E ratio also shows nothing about a company’s asset base.

Most analytics providers now calculate a forward P/E ratio as well as an historic one. The forward P/E ratio looks at forecast earnings, based on analysts’ expectations and calculates a figure from that. For example, the MSCI World had an aggregate P/E ratio of 17.4x as at 31 October 2022. This dropped to 14.9x for the forward P/E ratio. This suggests stocks are not as expensive looking at future earnings as they are on historic earnings.  

The Schiller P/E ratio is more complicated. This looks at cyclically adjusted earnings. It divides a company's stock price by the average of the company's earnings for the last ten years, adjusted for inflation. This is designed to show whether a stock is cheap or expensive based on its longer-term earnings profile, rather than just 12 months.

Price/earning ratios will give a measure of market sentiment. For example, there will be times when investors are willing to pay a high price for growth, such as when interest rates are low. Equally, it will vary from market to market and from sector to sector. The US market tends to trade on a higher P/E ratio than other markets because investors are willing to pay more for the type of high growth, high quality companies that list there. Technology tends to trade on higher P/E ratios because it has historically delivered stronger growth, while low growth sectors such as utilities will tend to trade on lower valuations.

For example, the P/E ratio of the S&P 500 peaked at over 40x in the fourth quarter of 2020. This was a good sign that share prices were starting to look stretched, though also reflected the weakness in earnings through the pandemic. The market didn’t peak until December 2021. This may not be a buy signal, but it can be a signal to look again at a particular market.

It can also help guide investors to areas that are unfairly out of fashion. If the P/E ratio is low, but there is no obvious reason for its weakness, this can be a sign that a sector is unloved and due for a reappraisal by the market. In this way, it can be a useful tool to uncover opportunities. It can also be a useful sell signal. If a company has moved to a high valuation, with no obvious change in its circumstances, this might be a moment to re-evaluate a holding.

While the P/E ratio cannot be predictive, it is a useful tool in alerting investors to anomalies in valuations. It can reveal where sentiment may be clouding investor judgement. However, it has its limitations and is more usefully employed alongside other metrics such as asset value to build a full picture of a company’s worth. 

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