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What is the P/E (Price-to-Earnings) Ratio?

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The Daily Ledger · Markets

At 45 times last year's profit, the stock's P/E ratio left little room for a disappointing quarter.

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Overview

The price-to-earnings ratio, or P/E, shows how many dollars investors pay for each dollar of a company's yearly profit. It is the share price divided by the profit the company made per share over the last year. A $60 share in a company that earned $3 a share has a P/E of 20. Put another way, the price equals 20 years of that profit. A high P/E is not automatically expensive. It usually means investors expect the profit to grow.
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Overview

P/E, the price-to-earnings ratio, is a share's price divided by one year of the profit behind it. Say the stock costs $100 and the business made $4 of profit per share last year: that's a P/E of 25. Now flip the fraction. The company makes $4 on every $100 share, which is 4% of the price, and traders call that the earnings yield. That's the number to hold up against what a bond or savings account pays you. One catch: the company keeps much of that 4% instead of handing it over. 😎

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Detail

The price-to-earnings ratio, or P/E, is a company's share price divided by its profit per share over the last year. It shows how many dollars the market pays for each dollar the company earns. A company whose shares trade at $50 and which earned $2.50 a share has a P/E of 20, so its price equals 20 years of that profit. Because it is a ratio, companies of any size sit on one scale. A share price alone cannot do that, because one company may split its profit across ten times as many shares as another. Investors pay 20 years of profit when they expect the profit to grow. The forward P/E is the same division using next year's forecast profit instead. If analysts forecast $5 a share, the forward P/E is 10. Profit doubling from $2.50 to $5 is what halves the P/E from 20 to 10. The ratio is only as good as the profit underneath it. Suppose $1 of the $2.50 came from selling a warehouse once. The profit that can repeat is $1.50, and the P/E on that is about 33, so the shares are dearer than 20 suggested. A company that made a loss has no meaningful P/E, and financial sites usually show it as blank. The number is also most useful between similar businesses, because a steady utility and a fast-growing software firm are expected to carry very different ones.
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Detail

P/E is the share price divided by a year of profit per share, which makes it a price tag written in years. A P/E of 15 means you're paying 15 years of current profit up front. Two quirks make it slipperier than it looks. First, the top of the fraction moves every second the market is open, and the bottom usually moves four times a year, when the company reports. So when a stock drops 8% on a Tuesday, its P/E drops 8% too, and nothing about the business changed. Second, a low P/E is sometimes a clearance sticker. A stock at 6 times profit might be a steal, or the market might have spotted that profit is about to shrink. If profit halves over the next year and the price stays put, that 6 becomes 12, and the bargain was never there. And if a company lost money, there is no P/E at all, just a blank where the number should be. So a high P/E is the stock saying next year will be bigger, and a low one is sometimes the stock saying it won't. Deciding which to believe is the actual job. 😎

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Analogy

The price-to-earnings ratio, or P/E, is a price divided by a year of profit, and people buying laying hens do the same sum with eggs. Say a young hen costs $30 and will lay about 250 eggs this year. A four-year-old hen costs $6 and will lay about 100. Per egg, the young hen costs 12 cents and the old one 6 cents. The old hen looks like the bargain, but she is cheap because she lays fewer eggs each year. The young hen costs more because she has years of laying ahead. A P/E works the same way. A high one means investors are paying for profit still to come, and a low one can mean the profit is shrinking. Where the picture breaks: you keep every egg, while a company keeps much of its profit and pays shareholders only part of it.
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Analogy

A P/E, the price-to-earnings ratio, is a price divided by one year of profit, so it is only as honest as that year. A seaside deckchair hire business is up for sale at $40K, and the owner says it cleared $20K profit last summer. That's a P/E of 2, which sounds like a steal. Then you check the weather. Last summer was the hottest on record, and a normal summer clears about $5K. On that, the same $40K is 8 years of profit. A P/E built on a freak year looks cheap because the profit is puffed up, not because the price is low. So before trusting a low P/E, ask whether that year's profit was the weather. 😎
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Formal definition β€” The same term, explained the usual way

The price-to-earnings ratio is a valuation multiple equal to the market price per share of common stock divided by earnings per share, where earnings per share is net income attributable to common shareholders, after preferred dividends, divided by the weighted average number of common shares outstanding. The trailing ratio uses reported earnings for the preceding twelve months; the forward ratio uses consensus estimates for the next twelve months or fiscal year. Equivalently, it may be computed as market capitalization divided by net income attributable to common shareholders. The ratio is not meaningful where earnings are zero or negative, and analysts frequently adjust earnings to exclude non-recurring items. Its reciprocal is the earnings yield.

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