The P/E ratio is one of many ratios investors use to evaluate whether a company’s shares are reasonably priced. The P/E ratio (or PE) is simply the price per share divided by the annual earnings per share. Equivalently, you can simply take the market capitalization divided by the total earnings.
For example, if a share is currently trading at $100 per share, and the company earnings $10 per share per year, the company’s PE is 10. All else being equal, shares trading with a low PE are better value than those with a high PE.
Something to watch out for with the PE ratio is that while the numerator P is the current share price, the denominator E is a trailing value – sometimes by more than you might expect. Often the earnings for the last complete fiscal year is used. If you’re already 3 quarters into the current fiscal year, that means the E in the PE ratio is a full 9 months out of date… and when the current full year results come out, the PE ratio can suddenly jump higher or lower, even if the share price P remains constant (which it won’t for long).
Consider, for example, a company with earnings of $40M in the most recent fiscal year, and a market cap of $200M. That would give it a PE of 5 – attractive enough to attract some punters looking for bargains. Now suppose you dig a tiny bit deeper and find that in earnings in the first three quarters of the current fiscal year are only $7.5M. Assuming the trend continues for the final quarter, the full year earnings would be ~$10 M… and the PE would suddenly jump to 200/10 = 20. Not so attractive.
If you’re lucky, a quoted PE will use the earnings over the most recent 4 quarters, in which case it’s sometimes written as “PE (ttm)” where “ttm” means “Trailing Twelve Months“. Even so it means the end date of that sliding 12-month window can be up to one quarter out of date, and its mid-point up to 3 quarters out of date.
In some ways, P/E is a bit of a silly ratio, as it goes to positive infinity as earnings approach zero… and flips to a huge negative number if a company reports a tiny loss. In fact, when earnings go negative, the PE is generally given as NA (“not applicable”).
Personally I prefer to think of the reciprocal of the PE ratio, namely the EP ratio – the earnings per share divided by the share price – as it’s well-behaved for earnings near zero, and meaningful even for losses. The denominator of the EP ratio never hits zero (though it can come frighteningly close, e.g. if you were unfortunate enough to hold shares in Nortel). EP is also easier to compare with interest rates (e.g. on bonds or fixed deposits). Consider a company with a very high PE ratio, say 50. That’s the same as an EP ratio of 0.02 or 2%. If shares in a company have a PE ratio of 50, you’re probably be better off owning a safe bond yielding 2%, unless you’re really confident the a company’s earnings will grow a lot in upcoming years.