The P/E ratio

In simple terms

The price-to-earnings ratio (P/E) compares what you pay for a share with the profit that share earns.

A P/E of 20 means investors are paying ₹20 for every ₹1 of yearly profit. Put another way, at today's profit level it would take 20 years of earnings to add up to the price.

P/E is the most widely quoted valuation ratio because it is simple and links price directly to profit. It is also one of the most misused.

Trailing and forward P/E

• Trailing P/E uses the profit of the last twelve months or the last financial year. It is based on reported numbers, but those numbers describe the past.
• Forward P/E uses forecast profit for the next year. It looks ahead, which is what investors care about, but forecasts are often wrong, and optimistic forecasts make shares look cheaper than they are.

When you see a P/E quoted, check which profit it uses. Comparing one company's trailing P/E with another's forward P/E is meaningless.

Earnings yield

Turning P/E upside down gives the earnings yield:

A P/E of 25 is an earnings yield of 4%; a P/E of 10 is 10%. Earnings yield makes it easier to compare shares with other investments, though with important caveats, covered in the yields lesson: profits are not all paid out, and they can grow or shrink, unlike a fixed interest payment.

What a P/E implies

A P/E is not just a measure of cheapness; it reflects what the market expects. Investors will pay more for each rupee of today's profit if they expect that profit to grow fast and steadily for many years.

So a high P/E is a bet on growth that has to happen, and a low P/E often reflects real problems. The question is always whether the market's expectations are too optimistic or too pessimistic.

When P/E fails

Losses. If profit is negative, P/E is meaningless. Use sales, cash flow or book-based measures instead.

Tiny profits. If profit has collapsed temporarily, P/E becomes very large and tells you little about value.

Cyclical peaks and troughs. At the top of a cycle, profit is unusually high and P/E looks low; at the bottom, the opposite. The cyclical businesses lesson explains why you should use average profit across a cycle.

One-off profits. A large gain from selling an asset inflates profit and lowers P/E for one year. Use recurring profit, as the quality of earnings lesson shows.

Different debt levels. P/E uses profit after interest. A company with heavy debt can show a low P/E that ignores the risk the debt creates; EV/EBITDA helps here.

Different accounting. Different depreciation lives or accounting frameworks can change profit, and therefore P/E, for otherwise similar businesses.

Using P/E sensibly

1. Use recurring profit, not profit flattered or depressed by one-offs.
2. Check trailing and forward P/E, and how reliable the forecast is.
3. Compare with the company's own history and with close peers, as the history and peers lesson explains.
4. Ask what growth the P/E implies, and whether that growth is likely.
5. Use other measures too, especially for financial, cyclical and loss-making companies.

The P/E ratio calculator works out P/E and earnings yield for any price and EPS.

Why it matters

P/E is the common language of share valuation. Quote screens, news reports and analysts all use it. Understanding what it does and does not tell you protects you from two common mistakes: buying shares because their P/E is low, and avoiding shares because their P/E is high, without asking why.

Limitations

P/E depends on a single year's profit, which may be unusual. It ignores debt, cash flow and the balance sheet. It is affected by accounting choices and one-offs, and it says nothing about the quality or durability of profit. It is a starting point for questions, not an answer.

Common mistakes

• Treating a low P/E as proof a share is cheap. It often reflects real problems or a cyclical peak.
• Comparing trailing with forward P/E.
• Using P/E for loss-making or deeply cyclical companies.
• Ignoring one-off gains that inflate profit.
• Comparing P/E across very different industries without adjusting for growth and risk.

Try it yourself

1. Choose two listed companies in the same industry.
2. Find each one's share price and its EPS for the last financial year, and calculate trailing P/E and earnings yield.
3. Check whether either company's profit included large one-off items, and recalculate P/E on recurring profit.
4. Write one sentence on what each P/E suggests the market expects.