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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