Investing Basics: What you need to know about the Price Earnings (P/E) ratio

Thursday, Jan 26 2012 by
Investing Basics What you need to know about the Price Earnings PE ratio

When it comes to valuing stocks, the price-to-earnings (P/E) ratio is the number one metric for investors that want an instant fix on what the market thinks of a company. But while the beloved P/E can tell you a lot about a share price there are health warnings to heed if you don’t want to be left exposed by its limitations.

What is the P/E ratio?

The price/earnings, P/E or ‘multiple’ as it is sometimes called compares a company’s stock price with its historic EPS, or earnings per share (which you’ll find on many websites or ideally in the company’s P&L statement). It is effectively a shorthand for how expensive or cheap a share is compared with its profits.  Alternatively, it can be calculated by dividing the company’s market capitalisation by its total annual earnings. 

As an example, online fashion retailer ASOS (LON:ASC) last year delivered a normalised EPS of 25.6p and saw its shares close on January 23rd at 1757p. By dividing those figures you arrive at a current P/E of 68. By comparison, stalwart high street retailer Marks And Spencer (LON:MKS) trades on a P/E of 8.8, while the FTSE All Share as a whole trades on a P/E of around 11.

While these ratios are generally calculated on the basis of historic earnings, it is worth noting that there are variations in the formula for arriving at P/E which can make comparison across different sources dangerous. At times you will see the stock price divided by the forecast EPS as a way of producing a ‘predicted’ P/E ratio using analysts’ expectations as a guide. Other times, the EPS figure will be produced from past two quarters and the forecast two quarters in order to smooth out the lag between annual results – this is known as the ‘rolling’ P/E and is the approach we typically use with Stockopedia Premium.

Another complication is that P/E ratios may be based on either reported earnings (i.e. exactly as per the company’s annual report) or normalised earnings (i.e. with adjustments for exceptional or non-recurring items). We use normalised earnings as we believe it makes for much more meaningful comparisons between companies.

What the P/E tells you

The P/E is a measure of how highly valued the company's earnings are in the market. So firstly it tells you…

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Marks and Spencer Group plc (M&S) is a retailer in the United Kingdom, with over 1,380 stores around the world. The Company is the holding company of the Marks & Spencer Group of companies. The Company operates through two segments: UK and International. The UK segment consists of the United Kingdom retail business and the United Kingdom franchise operations. The International segment consists of Marks & Spencer owned businesses in the Republic of Ireland, Europe and Asia, together with international franchise operations. The Company is engaged in delivering own brand food, clothing and home products in its stores and online both in the United Kingdom and internationally. The Company sells womenswear, lingerie, menswear, kidswear, beauty and home products, serving customers through approximately 300 full-line stores and Website, M& It has approximately 910 United Kingdom stores, including over 220 owned and approximately 350 franchise Simply Food stores. more »

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  Is LON:MKS fundamentally strong or weak? Find out More »

3 Comments on this Article show/hide all

FlightoftheKiwi 26th Jan '12 1 of 3

Hi Ben
I have some concerns with your article:
1. “The P/E is a measure of how much money a company earns for each one of its shares.”
The statement seems on face value to be incorrect. The amount of money that “a company earns for each one of its shares” is its EPS (earnings per share). The PE is the price the market is prepared to pay (the share price) divided by the earnings per share.
2. “and secondly, how many years an investor would have to wait to get back his investment through current earnings (assuming all earnings are paid out as dividends, of course!). “
I think this explanation is misleading because it is unrealistic. Many companies have earnings but do not pay dividends, and only in exceptional circumstances would a company pay out all of their earnings as dividends. There are also companies who pay dividends even though they have made a loss. There are too many other variables that define a company’s financial health for this idea to have much relevance. In other words, the idea that investors are concerned with how many years they would have to wait to get back his investment through current earnings is not a criterion investors find relevant.
3. “In essence, the PE tells us the degree of confidence that investors have in the future of the business. A PE ratio of 1 shows very little confidence in that business whereas a much higher PE expresses a great deal of optimism about the future of a business.”
As a broad generalisation this statement is true, however, it would perhaps have been better it your talked about a ‘normal’ range for PEs (e.g. 10 -15). Perhaps it would have been better to discuss the idea that a PE ratio of 6 being considered a low vote of confidence and a PE ratio of 30 shows that the market has a very high degree of confidence in the company's future? A PE ratio of 1 is so rare that for practical purposes it is ‘out of frame’.
You highlight ASOS as an example of a rapidly growing company with a high PE (68.7). You seem be using this company as an example of how a very high degree of confidence results in a high PE. As far as I can tell the more poignant feature of ASOS is that there is a very high risk that it is currently being grossly overvalued by the market. Although earnings have been growing at 45% PA, diluted earnings have not. If we assume a forward growth rate of 35% for revenue and earnings, the company would need to grow by a factor of 5 before the PE returned to the normal range. If the company cannot achieve this level of growth for each of the next 5 years then surely the omnipresent risk during this period will be that a falling SP that will fix the PE.

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nigelpm 27th Jan '12 2 of 3

I think the P/E ratio is a great measure of stock market confidence in a business i.e. the lower the ratio the less the stock market believes the future earnings of the business.

As with any measure it's absolutely useless on its own. You need to assess lots of other factors and measures.

That said I feel P/E Ratio (probably more 5-10 year historic average ratios) can work very well standalone on businesses that :

a) have very stable earnings - ie. Tesco
b) have a very strong competitive position and high barriers to entry

A classic example of where lots of people got too hung up on PER ratios was in the banks before the credit crunch. That taught me an incredibly valuable lesson.

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bargainvalue 27th Nov '15 3 of 3

I think the PE ratio is very useful and can be used even alone for effective market analysis. In my last article I present some intresting findings in this area. You can check it here:

Blog: Bargain Value
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