Lessons › Fundamentals and news › The P/E ratio
World 7 · Fundamentals and news · lesson 4 · level 2
The P/E ratio
The P/E ratio tells you how many years of today's profit you are paying for when you buy a share.
In one line
The P/E ratio tells you how many years of today's profit you are paying for when you buy a share.
Explained simply
Imagine buying a lemonade stand that earns 100 a year for 2,000: you are paying for 20 years of today's profit. The P/E ratio measures a share the same way, comparing its price with its yearly profit per share. A high number means buyers expect the profit to grow.
The lesson
The price-to-earnings (P/E) ratio is the share price divided by earnings per share, so a price of 200 with EPS of 10 gives a P/E of 20. A high P/E usually means investors expect fast growth, while a low P/E can mean the company is cheap or that it faces problems. P/E is most useful for comparing similar companies, or a company with its own history. It does not work for companies making losses, because there are no earnings to divide by.
A worked example
Illustrative example: a share costs 200 and the company earned 10 per share last year, so its P/E is 20 (200 divided by 10). A similar company costs 120 with EPS of 10, a P/E of 12 (120 divided by 10). Buying the first means paying 20 years of today's profit, against 12 years for the second, so the first needs faster growth to justify its price.
The same idea at four levels
- Beginner. P/E compares a share's price with the profit each share earned in a year.
- Foundation. P/E = price ÷ EPS, so a price of 200 with EPS of 10 gives a P/E of 20.
- Intermediate. A high P/E usually means investors expect fast growth; a low P/E can mean cheap, or it can mean trouble.
- Advanced. Compare P/E with similar companies or the company's own history, not across very different industries or countries.
- Expert. Experts ask why a P/E is high or low, check growth and risks, and remember that P/E does not work when a company makes losses.
Mistakes to avoid
- Calling every low-P/E stock a bargain without checking why it is low.
- Comparing P/E ratios across very different industries.
- Using P/E for a company that is making losses.
Check yourself
How is the P/E ratio calculated?
Share price ÷ earnings per share. P stands for price and E for earnings.
A share costs 200 and EPS is 10. What is the P/E?
20. 200 divided by 10 is 20.
What does a high P/E usually mean?
Investors expect fast growth. Buyers pay more for expected growth.
Can a low P/E be a sign of trouble?
Yes, it can signal problems as well as cheapness. Always ask why it is low.
A share costs 120 and EPS is 10. What is the P/E?
12. 120 divided by 10 is 12.
Goal of this lesson: Calculate and interpret the price-to-earnings ratio.