Two companies can have the same share price and be valued completely differently. The price-to-earnings ratio, usually shortened to the P/E ratio, is one of the simplest ways to compare them, and it is a number you will see quoted constantly once you start looking at shares.
The basic idea
The P/E ratio compares a company’s share price with its earnings per share, which is the profit it makes divided by the number of shares in issue. If a share costs £20 and the company earns £1 per share each year, the P/E ratio is 20.
Another way to think about it is how many pounds investors are paying for each pound of annual profit. A P/E of 20 means investors are paying £20 for every £1 of current earnings.
Trailing and forward
You will often see two versions. The trailing P/E uses earnings from the past twelve months, so it is based on real reported figures. The forward P/E uses analysts’ estimates of earnings over the next twelve months.
Each has its place. The trailing figure is grounded in fact but looks backwards. The forward figure looks ahead but depends on forecasts that can turn out to be wrong. When a company’s profits are changing quickly, the two can be very different.
What a high or low ratio might mean
A high P/E ratio usually means investors expect strong growth in future earnings and are willing to pay more today for that prospect. Many fast-growing technology companies trade on high multiples for this reason.
A low P/E ratio can mean a company is out of favour, that its growth is expected to be slow, or that investors are worried about its future. Sometimes a low ratio points to good value. Sometimes it reflects real problems.
That is the key lesson: the ratio on its own does not tell you whether a share is cheap or expensive. It tells you what expectations are built into the price.
Why interest rates matter
P/E ratios do not exist in a vacuum. When interest rates and bond yields are low, investors have fewer attractive alternatives, and they have often been willing to pay higher multiples for shares. When yields rise, safer investments start to look more appealing, and the pressure on high multiples can increase.
That link is particularly relevant at the moment, with the US 10-year Treasury yield at its highest level since 2002. Our explainer on how higher real yields pressure growth stocks goes into why companies whose value rests on distant future profits tend to feel this most.
Comparing like with like
P/E ratios are most useful when comparing similar companies. Different industries have very different typical ratios. A utility with stable but slow-growing profits will usually trade on a lower multiple than a software company growing quickly. Comparing the two directly can be misleading.
It can also help to compare a company’s current ratio with its own history, or to look at the ratio for a whole index. Index-level P/E ratios are often quoted as a rough guide to how richly the market is valued overall. Our guide to what stock indices are explains how those indices are put together.
The limits of the ratio
The P/E ratio has blind spots. Companies that make no profit do not have a meaningful ratio at all. One-off gains or charges can distort earnings for a year. Accounting choices can make profits look better or worse than the underlying business. And the ratio says nothing directly about debt, cash flow or the quality of management.
For those reasons, experienced analysts treat the P/E as a starting point rather than a verdict. It raises a question, why is the market valuing this company this way, and the answer usually requires looking at more than one number.
Using it sensibly
For a beginner, the P/E ratio is a useful way to start thinking about valuation and expectations. It is not a timing tool, and a high or low reading does not tell you when a share price will move. Treat it as one piece of context alongside the trend, the news and your own risk plan.
If you would like to build a more rounded way of analysing markets, our free trader assessment is a good way to see where your knowledge is strong and where it could grow.
