The P/E ratio: how many years of profit you pay for a share
In short
- The P/E ratio divides the share price by earnings per share and shows how many years of profit you pay for.
- A high or low P/E says nothing about good or bad until you know why the number looks the way it does.
- For cyclical companies and fast growers, the P/E of a single year gives a distorted picture.
- You use the P/E next to other measures, never as the only one.
Almost every stock page shows a number labelled P/E. It gets mentioned often and explained rarely. The sum behind it is simple. The interpretation is not.
The formula
The price earnings ratio (P/E, called K/W in Dutch) is the share price divided by earnings per share. A P/E of 20 means you pay 20 times one year of profit per share.
Think of it as a payback time on paper. If profit stayed the same year after year, you would earn back the purchase price in profit after 20 years. In reality profit never stays the same, so it is only a way of picturing it.
A worked example with an invented company
This example is made up and is not about any real company.
Say Fox Bread Ltd is a fictional bakery. It has 5 million shares and made €10 million in profit last year. Earnings per share are €10 million divided by 5 million, so €2.00. The share price is €40.
P/E = €40 divided by €2.00 = 20.
So you pay 20 times the profit. Flip it around and you get the earnings yield: 1 divided by 20 is 5 percent. That is profit as a percentage of the price. Note that this is not a return that lands in your pocket. The company can keep the profit, reinvest it or pay it out.
Now say Fox Bread makes €12.5 million next year. Earnings per share are €2.50. At the same price of €40 the P/E is 16. The price has not moved, but on paper the share got cheaper because profit rose.
Trailing and forward
There are two versions. The trailing P/E uses profit from the past twelve months. Those are reported figures. The forward P/E uses expected profit for the next twelve months. Those are analyst estimates, and an estimate can be wrong. Anyone reading a forward P/E is reading someone else's expectation. These are expectations of others, not a forecast by BitFox.
What the P/E does tell you
How highly the market values the company relative to its current profit. A high P/E generally means investors expect a lot of profit growth. The best comparison is with companies in the same sector, with the company's own history and with the broad market.
What the P/E does not tell you
Whether a stock is cheap or expensive. Research firm Edison notes that a low P/E does not guarantee a better return. Sometimes a stock is valued low because the market sees a problem.
The P/E also says nothing about debt, cash flow, dividends and share buybacks. Two companies with the same P/E can be built completely differently.
Where the P/E goes wrong
Cyclical companies. These are companies whose profit moves with the economic cycle, like steel or shipping. Take the invented Northern Steelworks. In a peak year it earns €8 per share and the price is €48: P/E 6. It looks dirt cheap. In a bad year profit is €0.50 and the price is €40: P/E 80. It looks absurdly expensive. Same company, two opposite signals. Analysts therefore often work with average profit over several years.
Growth companies. A young company that pours all profit back into growth sometimes has a P/E of 100 or more. That can be justified if profit rises fast. It can also mean expectations are too high. The P/E alone cannot show the difference.
Losses. If a company makes a loss, the P/E is negative and useless.
Accounting. Depreciation, inventory valuation and one off items differ between companies and countries. Comparing P/E ratios across borders calls for care.
Other measures in one paragraph
The PEG ratio divides the P/E by the profit growth rate so that growth counts: a P/E of 30 with 15 percent growth gives a PEG of 2. The CAPE (cyclically adjusted P/E, also the Shiller P/E) uses ten years of inflation adjusted earnings to smooth out the swings. Dividend yield and price to book value show what the P/E leaves out about payouts and assets. No single measure is enough. Together they make a picture.
What I think of it
I see the P/E as a good number to start a conversation and a poor number to base a decision on. It is quick to read, which is both its strength and its trap. Someone who goes only by a low number sometimes buys exactly the company whose profit is about to drop.
This is an explanation of a measure. It is not a verdict on any company and not advice to buy or sell anything.
