What is the price/earnings (P/E) ratio?
A quick way of asking: how much am I paying for every euro of profit?
The arithmetic and what it means
Divide the share price by the annual earnings per share. If the share costs €40 and the company earns €2 per share a year, the P/E is 20.
A useful way to read it: you are paying twenty years of today's profits. If profits never grew, it would take twenty years for the company to earn back the price you paid.
So a high P/E doesn't mean “expensive”, and a low one doesn't mean “cheap”. It means the market expects growth in the first case and trouble in the second.
A worked example
Two companies, same share price
Both cost €50. The first earns €5 per share, the second only €1.
Work out the P/E
The first has a P/E of 10, the second a P/E of 50. For the same price, the second gets you five times less profit.
The real question
Will the second company's profits grow fast enough to justify that gap? That is the entire investment.
Where it misleads
Earnings are an accounting figure, and accounting figures swing on one-off events: the sale of a building, a big fine, a restructuring.
A cyclical company has its lowest P/E right at the top of the cycle, when profits are inflated and about to fall. A low P/E there is a trap, not a discount.
And a company with no profit has no P/E at all. That doesn't make it a bad company — it just makes this tool useless for it.
How to use it in practice
The P/E only makes sense in comparison: with the company's own history, with its direct competitors, or with the whole market.
A P/E of 30 is high for a bank and perfectly ordinary for a software company growing 25% a year. Compare like with like.
Treat it as a first question, not an answer. It tells you what the market expects; it doesn't tell you whether the market is right.
Same P/E, different meanings
| Type of company | A P/E of 25 means | What to check |
|---|---|---|
| Growing software company | Normal | Are profits actually growing? |
| Bank | High | Why does the market expect growth? |
| Cyclical company | Could be the peak | Where is the cycle right now? |
Key terms in this lesson
- P/E ratio
- The share price divided by annual earnings per share.
- Earnings per share
- The company's profit divided by the number of shares outstanding.
- Cyclical
- A company whose profits follow the economic cycle, like steelmakers or airlines.
Quick check
A steel company has a P/E of 6, far below the market. What should you check first?
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