How to read a P/E ratio without being fooled by it

The price-to-earnings (P/E) ratio divides a company's share price by its earnings per share. A P/E of 20 means investors pay 20 units of price for each unit of yearly earnings. It is the most quoted valuation measure in investing and also one of the most misread. This article explains what it measures, the difference between trailing and forward versions, why a low number is not automatically cheap, and how to use it sensibly alongside other measures.

The basic calculation

P/E equals the share price divided by earnings per share (EPS). If a share costs 100 and the company earned 5 per share over the last year, the P/E is 20.

You can also turn it around. The earnings yield is EPS divided by price, which here is 5%. This makes it easier to compare with other returns, such as the yield on a bond. A P/E of 20 corresponds to an earnings yield of 5%, and a P/E of 10 to 10%.

What it tells you

The ratio says how much the market is paying for each unit of current profit. A high P/E usually means investors expect the earnings to grow, or consider the business safe and high quality. A low P/E can mean that the market expects slow growth, sees higher risk, or is simply undervaluing the company. It is a statement about expectations, not about whether a stock is a good or bad buy.

Trailing and forward P/E

• Trailing P/E uses the earnings reported over the last twelve months. It is based on facts, but it looks backward and can be out of date if the business is changing quickly.
• Forward P/E uses analysts' estimates of next year's earnings. It looks ahead, but it depends on forecasts, which can be wrong or overly optimistic.

If the company has an EPS of 5 now and analysts expect 6 next year, a 100 share has a trailing P/E of 20 and a forward P/E of about 16.7. Always check which one you are looking at, and where the estimate comes from.

Why a low P/E is not automatically cheap

• Peak earnings. For cyclical businesses, such as miners or carmakers, earnings swing with the economy. At the top of the cycle earnings are high, which makes the P/E look low, just before they fall. At the bottom, earnings are depressed and the P/E looks very high. A company earning 10 per share at a 100 price at its peak has a P/E of 10, but if earnings fall to 2 the P/E becomes 50. Looking at average earnings over several years can help.
• A shrinking business. A company with falling revenue can deserve a low multiple.
• One-off items. Gains from asset sales, or charges for restructuring or legal settlements, can distort the figure. Look at what is recurring.
• Accounting differences. Companies may report adjusted earnings that exclude certain costs, which flatter the ratio.
• Debt. Two companies with the same P/E may have very different levels of borrowing, and therefore different risk.

Why a high P/E is not automatically expensive

A fast-growing company may have a high P/E because its earnings are expected to rise quickly. If they do, the P/E will fall as earnings catch up with the price. The danger is that expectations are already high, so any disappointment can lead to a sharp fall in the share price.

Companies with no earnings

If a company has losses, the P/E is not meaningful and is usually shown as not applicable. For such companies, investors look at other measures, such as price to sales or progress toward profitability.

Related measures

Use P/E together with other lenses.

• PEG ratio: P/E divided by the expected earnings growth rate in percent. A P/E of 20 with growth of 10% gives a PEG of 2. It tries to account for growth, but depends on the growth forecast.
• Price to free cash flow, which looks at cash rather than accounting profit.
• Enterprise value to EBITDA, which includes debt and is useful for comparing companies with different capital structures.
• Price to book, often used for banks and asset-heavy firms.

Compare like with like

Typical P/E levels differ widely between industries. Software companies, banks, utilities and miners trade at very different multiples because their growth, risk and capital needs are different. Compare a company with its direct peers, with its own history, and with the broader market, but not with unrelated sectors.

A simple way to use it

1. Check whether the P/E is trailing or forward, and which earnings figure it uses.
2. Adjust for one-offs and for where the company is in its cycle.
3. Compare with peers and with the company's own range over the past 5 to 10 years.
4. Ask why the multiple is where it is: growth, risk, quality, or temporary conditions.
5. Cross-check with cash flow, debt and margins.

Common mistakes

• Treating a low P/E as proof of a bargain.
• Comparing across industries.
• Ignoring the cycle for cyclical companies.
• Relying on one year of earnings.
• Forgetting that forward P/E depends on estimates.

A short checklist

• I know whether the P/E is trailing or forward.
• I have adjusted for one-off items.
• I have compared with peers and history.
• I have checked cash flow and debt.

No single ratio settles whether a stock is a good investment. Treat P/E as a starting question that points you to what to investigate next, not as an answer.