The price to earnings ratio, or P/E, compares a company’s share price with its earnings per share. In short, it shows how many pounds investors are willing to pay for £1 of annual profit.
If a stock trades on a P/E of 15, buyers are paying £15 for each £1 of earnings based on the period used. The ratio is a quick way to stack shares against peers, gauge how optimistic the market is about future growth and sanity check a valuation.
What the P/E ratio actually measures
The P/E puts today’s equity price next to a measure of profit that belongs to shareholders. That profit is earnings per share, which is net profit after interest and tax divided by the number of shares. The idea is simple: the higher the P/E, the more future growth, quality or stability investors think they are getting. The lower it is, the more cautious the market tends to be about those same things.
Flip the P/E over and you get the earnings yield, which is earnings per share divided by the price. If a share has a P/E of 20, the earnings yield is 5 percent. Some investors prefer this view because it looks like a return figure, though it is only a rough guide and assumes profits hold steady.
Calculating P/E: price, EPS and a quick example
There are two equivalent ways to calculate a P/E. Both aim to match a price with the right measure of profit for the same period.
- Per share method: P/E equals share price divided by earnings per share. Example: price £30, EPS £2, P/E is 15.
- Whole company method: P/E equals market capitalisation divided by total net income. Example: market cap £3 billion, net income £200 million, P/E is 15.
Step by step using the per share route:
- Pick a price. Many sources use the latest close. Some use an average. Be consistent when comparing companies.
- Find EPS for the same period. That could be the last financial year, the last 12 months, or a forecast for the next year.
- Divide price by EPS.
Small example: a retailer trades at 240p. Its last 12 months EPS is 30p. The trailing P/E is 240p ÷ 30p, which is 8.
Mind the fine print on EPS. Companies report basic and diluted EPS. Diluted adjusts for potential new shares from options or convertibles, which lowers EPS and lifts the P/E. Some reports exclude exceptional items to show an underlying figure. Know which one you are using before you compare it with other names.
Trailing vs forward P/E and other variants
P/E depends on the earnings period you plug in. The most common versions are:
- Trailing P/E: uses earnings from the past, often the last full year or last 12 months. It is based on what actually happened.
- Forward P/E: uses analysts’ forecast EPS for the next year or next 12 months. It reflects expectations and will change as estimates move.
Some investors use a blended approach that averages trailing and forward numbers across a transition period. Others prefer a normalised P/E that strips out one‑off gains or losses and adjusts for a full cycle. For broad indices, you may also see a cyclically adjusted version that uses multi‑year average earnings to smooth booms and busts.
Because definitions vary by source, check the footnotes on any factsheet or screener before comparing ratios across providers.
How investors use P/E in practice
In everyday use, P/E sits next to market cap, dividend yield and growth rates on research notes, factsheets and screening tools. Here is how it helps:
- Peer comparison: compare a bank’s P/E with other banks, or a software firm with other software firms. A premium suggests stronger growth or quality. A discount can hint at lower growth, higher risk or simply a lagged perception.
- Growth framing: a high P/E is common for businesses expected to grow earnings quickly. The risk is that growth disappoints. Even small misses can cause a sharp de‑rating.
- Value hunting: a low P/E can signal undervaluation if profits are steady and the balance sheet is sound. It can also be a value trap if earnings are about to fall.
- Yield comparison: some compare the earnings yield with bond or cash yields as a rough opportunity‑cost check. This is a blunt tool because business risk and growth prospects differ from fixed income.
P/E also shows up at the market level. Commentators may say an index trades at a P/E above or below its long‑run average, often as a shorthand for how confident investors feel about the future path of earnings.
Limits and common traps to watch for
P/E is popular because it is simple. That simplicity hides pitfalls:
- Loss‑making companies: if earnings are negative, the P/E is not meaningful. You might see N/A or a dash. For early‑stage or turnaround stories, other ratios such as revenue multiples can be more useful.
- One‑offs and accounting choices: disposal gains, impairments, tax credits and changes in accounting standards can swing EPS. Adjusted or underlying EPS tries to remove these, but adjustments vary, so read the reconciliation.
- Share count changes: buybacks reduce the number of shares and can lift EPS even if total profit barely moves. Issuing new shares does the opposite. The whole‑company P/E using market cap and total profit avoids this distortion.
- Sector differences: capital‑intensive or cyclical sectors often trade on lower P/Es in mid‑cycle. Asset‑light or higher‑growth sectors often carry higher P/Es. Comparing across very different industries can mislead.
- Financials and special cases: P/E is widely used for banks and insurers, but price to book and return on equity are also central because balance sheets drive earnings capacity.
- Timing mismatch: using a mid‑day price with last year’s EPS is fine if you know it, but mixing sources can skew comparisons. Align the price point and the earnings window.
Another subtlety is cyclicality. For miners, shippers and other cyclical names, profits can spike near the top of a cycle, making the P/E look cheap right before conditions turn. Normalising earnings over a cycle can give a fairer picture.
Bringing it together with a worked comparison
Imagine two companies at £25 per share:
- Company A earned £1.25 per share last year, expected to earn £1.40 next year. Trailing P/E is 20, forward P/E is about 17.9.
- Company B earned £2.50 per share last year, expected to earn £2.10 next year. Trailing P/E is 10, forward P/E is about 11.9.
On last year’s numbers B looks cheaper. On forward numbers the gap narrows because B’s earnings are forecast to fall while A’s are forecast to rise. Without understanding the drivers, the headline P/E can be misleading. Pair it with growth, margins, cash generation and balance sheet strength to form a fuller view.
Used with care, P/E is a handy first filter and a good way to translate prices into plain profit terms. Just make sure you know which earnings it uses, why the market assigns a premium or discount, and how likely those earnings are to persist or grow.