P/E Ratio

The percentage and earnings (P/E) ratio shows the number of years' earnings per share (EPS) contained in the current share price. In other words, it shows the number of years at current earnings needed to cover the current share price.

The price/earnings ratio (P/E ratio) is commonly used to assess the level of confidence investors have in a company. It represents the market's view of a company's growth potential. Investors try to identify undervalued stocks by comparing P/E ratios between companies and across business sectors.

A high price/earnings ratio indicates that investors have a high level of confidence in a company's future. But while a company with a high P/E ratio relative to its sector may have exciting growth prospects, it might equally be considered to be overvalued depending on the prevailing market circumstances. So while P/E can be a useful measure of a company's value, it should also be treated with caution.
How is the P/E ratio calculated?

To calculate P/E ratio, divide the stock price by the post-tax earnings per share (EPS). To calculate earnings per share, divide a company's 12-month earnings by the number of outstanding shares.

If a company's earnings are £2 million and the number of outstanding shares is 1 million, it has an earnings-per-share figure of £2.

Now you can work out the P/E ratio by dividing the stock price by the EPS. So if the stock price is £30 and the EPS is £2, then the P/E ratio is 15.
Using the P/E ratio

Like most performance indicators, the P/E ratio is most revealing if it is monitored over a long period. That way, it is possible to uncover trends rather than relying on snapshots of a given moment.

When using P/E to analyse companies, always use consistent information. Most P/E figures are reported using 'trailing' earnings (ie, the earnings for the past 12-month period). But some brokers report P/E figures on 'leading' earnings (ie, the projected earnings for the next reporting period).

It's also wise to eliminate any one-off gains or losses when comparing P/E ratios so that you can arrive at an accurate earnings figure.
New valuation measures

P/E ratios vary dramatically between sectors. For example, the high-tech economy has seen high valuations of companies that are making huge losses. Some brokers have even begun to calculate negative P/E ratios in order to compare these companies. Other brokers simply refuse to quote a P/E ratio for a loss-maker.

Companies have traditionally been valued using P/E multiples, but it is now commonplace to value companies on the basis of projected turnover - even though they may be making big losses. Meanwhile, high-tech companies that are actually making money carry extremely high P/E multiples.

These measures are a long way removed from standard practice, and their usefulness is questionable. It is vital to exercise discretion and apply balanced judgment when relying on P/E multiples for investment decisions.