Understanding A P/E Ratio (Price To Earnings Ratio)

What is a P/E Ratio?

The 'P' stands for Price and the 'E' for Earnings. The two most important things in investment - the price you pay and the earnings you own.

P/E ratio = share price divided by Earnings per share (EPS)

At it's most straightforward ... the p/e ratio is a notional number. It is used to provide a notional number of years (in current profit terms) that it will take to 'earn' the current share price. In other words, if a firm has a p/e of 10, you could estimate that the company needs to earn the same profits for 10 years to 'break even' on the share price. This is considered to be the 'forward' version. Needless to say, such estimations are fraught with errors.

A p/e also describes how a firm is 'rated' by the market. A high p/e ratio presumes that the market expects earnings per share to rise and growth to be strong. The market may view an above average p/e to be a sign that a company is a 'growth' share.

A low p/e ratio therefore, suggests the opposite. Opinions of the market suggest that growth may be 'low' or 'unreliable' or perhaps the expectation is that the company is soon to disappoint.

Companies will often be rated against their peers in a specific sector. This is a useful way to view the market's opinion of a company against other similar enterprises. A business may have a rating that is out of line with the average for the sector. This may suggest that the company is expected to grow more quickly or slowly than the sector average. It is only really when compared to others and the market that it can be decided whether a company has a good p/e ratio or not.

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It is also possible to manipulate the data for other means as this description of the Shiller P/E ratio suggests. As I am sure all readers know, statistics can be used in all sorts of ways, including historic p/e ratios.

All these little factors may have an important bearing upon your investment and the returns achieved so be sure to grasp this concept.

The financial press will often write about the ratio of the 'market'. By using computer algorithms to calculate the rating of every company on the stock exchange and then to divide by the number of quoted companies, an average can be provided. By comparing this average to other historical averages, it is possible to start estimating whether the market is cheap expensive at the time.

This same concept can be used to gauge the relative value of one entire market against another. For example, it is possible to compare the p/e ratio of the markets in France and Germany. This can help to provide macro asset allocation decisions.

While such comparisons may not sound obviously useful to most private investors, such tools can offer useful insights to professionals. Even then, most professional money managers are bound by their fund's rules to only invest in certain sectors or markets. However, for the fleet-footed hedge fund managers - the 'hot money' - such insights can be very valuable.