Price-to-earnings ratio (P/E)

A company's price-to-earnings (P/E) ratio tells you how much investors are willing to pay per unit (£1, $1, €1) of a company's earnings. For this reason, it is sometimes nicknamed the "price multiple" or the "earnings multiple."

It is calculated by dividing its market value per share by its earnings per share:

PE = Market value per share/earnings per share

For example, if a company's stock is currently trading at £40 per share, and its earnings per share have averaged £2 over the previous four quarters, its P/E ratio for the year would be 20.

This means that investors buying the stock now need to pay £20 for every £1 of earnings generated by each share.

P/E shows the desirability of the company's shares compared to other companies

The P/E ratio therefore tells us how attractive a share is relative to other shares. The higher the P/E, the more money shareholders are prepared to invest for the same £1 of earnings

This gives P/E its most important use for equity investors – it helps them decide whether a company's share is overpriced or underpriced compared with the company's real, fundamental value and with other shares in the same sector.

Caution with very high P/E figures

A high P/E ratio may indicate a share is overpriced, in which case you may decide to sell it on the expectation that its inflated price will soon collapse and it will fall back to its real value.

Conversely, a low P/E ratio may indicate that a share is underpriced or cheap, in which case you may decide to buy it on the expectation that other investors will soon become aware of its fundamental strengths and its share price will rise to its real value.

Generally, a P/E lower than 15 indicates that a company's shares are currently undervalued, while a P/E ratio higher than 20 indicates that its shares are overvalued.

Take into account the industry and size of the company

This is only a very loose rule however, as P/E ratios tend to be different based on the industry in which a company operates and on its size.

Technology companies, for example, tend to have higher P/E ratios than other sectors because their growth rates are usually higher and they give investors a higher return on equity. In contrast, utility companies tend to have a lower P/E ratio.

Consider P/E over time

Another way of using P/E ratios is to look at a company's P/E over a period of time.

If, for example, a company's P/E ratio has risen significantly higher than its historical average P/E ratio, and you cannot find fundamental reasons to justify that – for example, a hot new product – this may indicate that its shares are overpriced and now might be a good time to sell.

The same can be applied to entire sectors. If, for example, the average P/E ratio of pharmaceutical companies has dropped significantly below its historical average, and you can find no fundamental reason to explain this, it might indicate pharmaceutical shares in general are currently underpriced. This means that now might be a good time to buy pharmaceutical shares.

At this point, you could apply the P/E ratio to individual companies in the pharmaceutical sector to work out which in particular seem most underpriced.

Bear in mind that, similarly to the EPS ratio used in its calculation, the P/E ratio relies on companies reporting their earnings accurately.

It is of course possible for companies to manipulate their earnings, so the P/E ratio should never be relied on as your sole indicator before deciding whether to buy or sell a share.