The Price to Earnings Ratio (also called the PE ratio) is the primary valuation ratio used by most equity investors. It is a measure of the price paid for a share relative to the annual net income or profit earned by the firm per share. A high P/E ratio means that investors are paying more for each unit of net income, so the stock is more expensive compared to one with a lower P/E ratio. The P/E ratio can be seen as being expressed in years, in the sense that it shows the number of years of earnings which would be required to pay back the purchase price, ignoring inflation.
This is a rolling ratio which means that it weights FY1 and FY2 forecasts depending on how far a company is through its reporting period. This makes apples and oranges more comparable - otherwise you might be comparing one company on a forecast P/E for a company reporting tomorrow with a company reporting in 11 months!
Investors have a tendency to overreact becoming enamoured with glamour stocks (pushing their PE too high) while becoming disenchanted with value stocks (pushing their PE too low). Research has shown that low P/E ratio stocks tend to outperform high PE stocks in the long run. On the other hand, there are many investors who believe that you should 'pay up for quality' in the same way people pay for jewellery - the best growth stocks therefore rarely trade for cheap PE multiples.
Unlike the EV/EBITDA multiple which is capital structure-neutral, the price-to-earnings ratio reflects the capital structure of the company in question. The reciprocal of the P/E ratio is known as the earnings yield.
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