How To Understand ‘Price Earnings (P/E) Ratio’ (2024)

Any discussion about investing in shares will, sooner or later, mention their ‘price earnings ratio’ – usually shortened to P/E ratio.

So what is it, and what can it tell us about individual shares, their competitors and the markets they are in?

Here’s our explanation of a P/E ratio and how to use it when evaluating whether or not to invest in a company.

What is a P/E ratio?

In its simplest form, the P/E ratio is calculated as the share price of a company divided by its earnings (net profit) per share (EPS).

It measures how much investors are willing to pay for a company relative to its current earnings, which reflects investors’ expectations of future earnings growth.

Say a company has a share price of 150 pence and EPS of 30 pence. Its P/E ratio is therefore 150 divided by 30, or 5. This tells us that the shares are trading at five times current earning levels.

The higher a P/E ratio, the more investors are expecting to see a high level of earnings growth that will justify the relatively high cost of buying the share.

P/E ratios have been in the spotlight in recent years thanks to the heady valuations of US technology companies. In 2020, Tesla made headline news when its P/E ratio hit over 1,300, compared to an average ratio of just 20 for the tech-heavy Nasdaq.

Tesla (TSLA) share price

However, as US stock markets enter bear market territory, technology companies have seen significant valuation downgrades, with Tesla now trading on a P/E ratio of 54. Facebook’s parent Meta has suffered a similar fate, with its P/E ratio dropping from a high of 18 to a low of 9 last year.

Delving deeper

There are two different types of P/E ratios:

• The ‘trailing’ or historic P/E ratio is based on actual EPS for the last 12 months (known as trailing 12 month earnings) or the last financial year.
• The forward P/E ratio is based on forecast EPS for the next financial year, provided by the company and/or analysts.

Let’s look at a real-world example: Barclays’ share price is currently 147 pence, and its trailing earnings per share are 30 pence per share. Its trailing P/E ratio is therefore 4.9 (147 divided by 30).

What does this mean? Prospective buyers of Barclays shares are prepared to pay a multiple of just under 5 times current earnings to invest in the company.

Or, put it another way, it would take 5 years of accumulated earnings for investors to cover their initial investment.This implies that investors expect low earnings growth.

P/E ratios also reflect investors’ perception of the risk associated with investing in the company – a low P/E ratio may indicate that investors believe that there is a high risk of the company failing to meet earnings expectations.

How to use P/E ratios to value shares

It’s important to note that a P/E ratio is relative, meaning that it’s of limited use without comparing it against its (publicly listed) competitors and the wider stock market.

Let’s take a look at the different P/E ratios of ‘growth’ and ‘value’ shares.

1. What are typical P/E ratios for growth shares?

The US technology companies have some of the highest P/E ratios. Some investors expect a high level of growth in earnings and, as a result, are willing to pay a higher price for these shares relative to their current earnings.

These are the current trailing P/E ratios of four of the largest US technology companies:

As expected, the companies with the highest P/E ratios typically have the highest forecast growth in earnings. However, investors will be looking for earnings growth over a longer period than the three years shown in the table above.

Netflix has the highest P/E ratio of 31, significantly above the ratios of the other stocks in this cohort and the Nasdaq 100. However, its forecast earnings growth is similar to Meta and Alphabet which are trading on much lower P/E ratios.

Netflix (NFLX) share price

Does this mean that Netflix shares are overvalued? Not necessarily, as the P/E ratio should be considered alongside other factors.

For example, investing in research and development (R&D) will depress current earnings but should generate higher earnings in the future – Netflix has more than doubled its R&D expenditure over the last five years. The company’s EPS also fell by more than 11% in 2022 which increases the historic P/E ratio but its forward P/E ratio will therefore decrease due to the forecast recovery in earnings.

At the other end of the scale, Alphabet is trading on the lowest P/E ratio of 23, but has similar forecast earnings growth to Meta and Netflix.

Alphabet has fallen out of favour with investors over the last year, with its share price falling by nearly 40% in 2022. The company reported earnings below expectations and concerns about macroeconomic headwinds have taken their toll on its share price, and, by extension, P/E ratio.

Alphabet (GOOGL) share price

2. What are typical P/E ratios for ‘value’ shares?

A low P/E ratio is often used as a way of identifying ‘value’ shares – this may indicate the shares are good ‘value’ as their share price is below their underlying or ‘intrinsic’ value. However, this is not always the case as a low P/E ratio may simply reflect their lower growth potential.

The FTSE has a higher proportion of value shares, compared to the growth shares that dominate the Nasdaq. Many of the FTSE companies operate in mature industries such as energy, financials, industrial products and mining.

Let’s take a look at the trailing P/E ratios of selected FTSE 100 companies:

Overall, the P/E ratio of the FTSE 100 is only 14, compared to 25 for the Nasdaq 100, which is to be expected given the higher proportion of value shares in the FTSE. Although forecast earnings growth is slightly lower than the group of four US stocks we looked at, there is also less of a correlation between the P/E ratio and earnings growth.

One major difference relates to dividend policy. Many of the US growth shares do not pay dividends, preferring to reinvest surplus profits to generate future growth. In turn, this should push up the share price and create future profits for investors.

However, these FTSE companies have a high dividend yield of between 4-5%, which is a measure of the income shareholders will receive as a proportion of the current share price. This can also have a positive impact on the share price if demand for the share rises due to income-seeking investors.

Why is Tesco trading on a higher P/E ratio than Sainsbury’s? Well, Tesco has higher forecast earnings growth of 5%, compared to a decrease of 1% for Sainsbury’s.

While Tesco is trading on a slightly lower dividend yield, it has a considerably higher market share than Sainsbury’s, which may help it to maintain profits during the current cost-of-living squeeze. These stronger fundamentals may tempt investors to pay a higher price for Tesco shares relative to Sainsbury’s.

Similarly, HSBC is trading on a P/E ratio of 9 compared to 8 for NatWest. As expected, HSBC has substantially higher forecast growth in earnings of 22%, versus 10% for Barclays.

HSBC also has a high dividend yield, and achieved higher-than-expected earnings in 2022. All of these factors have a positive impact on its P/E ratio.

Why have P/E ratios fallen recently?

Investor sentiment has a significant impact on share prices, and by extension, P/E ratios. Fears over high inflation, rising interest rates and geopolitical uncertainty have taken their toll on valuations over the last 18 months.

Higher interest rates have hit the valuations of technology companies particularly hard, by reducing the current value of their future cash flows. According to WSJ Markets, the average P/E ratio of the Nasdaq 100 has fallen from 33 to 25 over the last year.

However, the P/E ratio of FTSE 100 has held up at around 13-15 over the same period, principally due to its higher proportion of value shares. During an economic downturn, many investors tend to switch from growth to value shares as their more defensive characteristics can make them more resilient.

David Jones, chief market analyst at Capital.com, comments: “The FTSE is full of what might be termed “plodders” – solid blue chip stocks that make a profit and pay a dividend. Their defence quality has come to the fore in 2022. They’ve been hit much less hard than many of the S&P’s (US stock market) high-growth constituents.”

What limitations do P/E ratios have?

As with other ratios, the P/E ratio should be compared to the P/E ratio of similar companies, not used as a standalone measure on its own. Other financial measures such as profit margin, dividend yield, cash flow and net debt should also be considered when looking to invest.

In addition, it’s worth noting the following limitations of P/E ratios:

• share prices can be highly volatile, with a knock-on impact on P/E ratios
• different measures of EPS can have a significant impact on the P/E ratio, such as trailing or forward EPS, or adjusted EPS to remove one-off items. What’s more, EPS is a snapshot at a point in time, and may not be representative of average earnings
• a P/E ratio can’t be calculated for a loss-making company
• a company may not meet its EPS forecasts which impacts the reliability of forward P/E ratios
• the EPS doesn’t adequately reflect the financing structure of a company. A company with higher debt may have a lower EPS due to interest payments. However, debt can have a positive effect on future earnings growth if the money is invested in the business.

Should you buy shares with a low P/E ratio?

Overall, the P/E ratio is a useful valuation tool but should be used with caution. It’s tempting to see companies trading on a high P/E ratio as ‘overvalued’. But if that company delivers significant earnings growth, resulting in a higher share price, then its higher valuation is justified.

Similarly, a company trading on a low P/E ratio might have potential upside in its share price if it achieves higher-than-expected earnings growth. Or investors are attracted by its dividend yield, with an increase in demand for dividend-paying shares also pushing up share prices.

However, the company might equally be trading on a low P/E ratio for a good reason as it has financial difficulties or operates in a cyclical industry about to hit a downturn.

There’s also the possibility that a company may be inflating earnings by devaluing or hiding costs. Ultimately, it’s not recommended to solely rely on the P/E ratio.