Price-to-earnings ratio

What it means

The price-to-earnings ratio is the market price of a share divided by earnings per share. It shows how many years of current profit investors are willing to pay. If a share costs 100 euros and earnings per share are 10 euros, the P/E is 10, so the investor pays ten times annual profit.

A high P/E suggests the market expects rapid profit growth or sees the company as very stable. A low one may signal undervaluation, but also doubts about the future, for instance in a declining industry. The number alone, without context, says little.

P/E is also used to value private companies by comparison with similar listed ones. For small firms the EV/EBITDA multiple is used more often, because it is unaffected by debt levels and by differing tax or depreciation policies.

How it works in practice

There is a trailing P/E based on last year's profit and a forward P/E based on expected profit. Comparisons must use the same type. For cyclical companies it is better to use average profit over several years, because one exceptional year distorts the figure badly.

When a stake in a small company is sold, the buyer often argues in multiples of profit. The seller should know which profit is meant: whether it has been adjusted for one-off items, an owner's above-market pay or private expenses run through the company.

The inverse of P/E, profit divided by price, is called the earnings yield and can be compared with interest rates or the dividend yield. For a more precise valuation, multiples are complemented by the DCF method, which works with future cash flows.

What to watch out for

When a company makes a loss, P/E is negative or undefined and cannot be used. Valuation then relies on sales, cash flow or assets. Profit can also be shaped by accounting choices, so it is worth comparing P/E with the price-to-cash-flow ratio.

Comparing P/E across industries or countries is misleading. Different growth rates, risks, interest rate environments and tax rates lead to entirely different normal multiples; the comparison only makes sense against genuinely similar companies.