What is a P/E Ratio (Price-to-Earnings)?

Definition of the P/E Ratio

The P/E Ratio is calculated by dividing the market price per share by the earnings per share. It is a key indicator of a company's financial health and market expectations. All else equal, a low P/E Ratio (below 10) would indicate the shares are cheap while a high P/E Ratio (greater than 20) would indicate the shares are expensive. But take note of the 'All else equal' here. A company close to bankruptcy, with poor future prospects and operating in a highly volatile environment may have a low P/E Ratio while still not presenting an attractive investment opportunity. On the other hand, a company with a very high P/E Ratio could be a very attractive investment opportunity if the future for that company looks very promising.

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Why Is the P/E Ratio Important?

As an investor the key question to be answered is whether the price paid for a share is low, fair or high relative to the true underlying value of that share. This is clearly the most fundamental consideration when deciding when to buy and sell a share and is also one of the most challenging to assess correctly, mainly because the 'true underlying value' of the share is difficult to assess. The P/E Ratio is a measurement which can help to better address this question.

The most important and most attractive feature of the P/E Ratio is that it is a metric which is independent of the size of the company, the number of shares the company issued, the tax regime in which it operates, the amount of debt taken on by the company and the actual value of the shares. This means it is possible to compare the share prices of different companies even though they may be of very different sizes and have very different share prices. In this way it is possible to compare for example Mercedes-Benz and BMW equities (try the Compare function) and it can be seen that, at time of writing, they have almost identical P/E Ratios. There is therefore little to differentiate these two companies in terms of potential investment returns even though the share prices themselves are quite different. This should be expected because these companies operate in the same market, they are both mature companies, located in Germany.

However, there are quite a few pitfalls to bear in mind too when using the P/E Ratio. To start with this is not a metric that can be easily applied when comparing companies which are in different stages of their development. When Tesla started production its earnings were close to zero, if not negative, so the P/E Ratio was very high or even negative. The superficial conclusion might have been that the share price was far too high, in any case compared to a company like Ford which already had stable earnings. But this would not have been the correct application of the P/E Ratio: young companies need to be assessed in terms of their future potential and not using the momentary snapshot of the P/E Ratio.

Care also has to be taken when comparing companies across industries. Stable companies producing food can be considered lower risk than luxury tour operators: food is always needed while demand for luxury tours may decline in times of economic downturns. The food company can therefore be considered lower risk than the tour operators and as such an investor is likely to accept lower returns for the former and demand higher returns for the latter. The P/E Ratio for the food companies is therefore likely to be higher than that for the tour operator which is mainly a result of the different risks involved.

There are other limitations of using the P/E Ratio but many of the limitations can be mitigated by not only looking at the current P/E Ratio but also at the expected P/E Ratios for the coming years. Equities on UMushroom therefore display not only the current P/E Ratio, but also the P/E Ratios to be expected for the coming 3 years. These values are important because they reveal what the analyst community believe will happen going forward. A decreasing P/E Ratio is attractive because this means that future earnings may rise, and vice versa. 

In summary, making successful investment decisions not only depends on the current situation as shown by the current P/E Ratio amongst many other indicators, it also depend on a good understanding of the future since the future is what is important for the share price. Accordingly, the expected change in the P/E Ratio for the coming years also needs to be taken into consideration when making any investment decision.

Common Misconceptions About the P/E Ratio

• "A High P/E Ratio Always Means a Stock is Overvalued": While a high P/E Ratio can suggest overvaluation, it may also reflect expected growth in earnings, lower risk or a company just starting up.
• "P/E Ratio is the Only Metric to Consider": Investors should use the P/E ratio in conjunction with other financial metrics and analysis methods for comprehensive evaluations.

Conclusion

The P/E Ratio is one of many indicators available when assessing a potential equity investment. It allows the comparison of companies of different sizes, across tax regimes and with varying levels of debt but it should be used with caution when comparing companies across different industries, companies in different stages of development, etc. Since the value of a share is however fundamentally determined by the future health of the company, the trend of the expected P/E Ratios over the coming years is perhaps the more valuable metric (decreasing = good, increasing = bad).

FAQs About P/E Ratios

Q: What is considered a good P/E ratio?
A: A "good" P/E ratio varies by industry and market conditions, but a ratio below the industry average may indicate undervaluation.
Q: Can the P/E ratio be negative?
A: Yes, if a company reports negative earnings, the P/E ratio will be negative, which complicates valuation analysis.
Q: How can I find a company's P/E ratio?
A: P/E ratios can be found on financial news websites, investment platforms, and company financial statements.

Related Terms

• Earnings per Share (EPS): A company's profit divided by the number of outstanding shares, used to calculate the P/E ratio.
• Market Capitalization: The total market value of a company's outstanding shares, influencing its overall valuation.
• Growth Stock: A stock that is expected to grow at an above-average rate compared to other companies.