The P/E Ratio: What It Tells You and What It Hides

The price-to-earnings ratio, or P/E, is a share’s price divided by the company’s earnings per share. A P/E of 20 means investors are paying ₹20 for every ₹1 of profit the company earned in a year. It is the most widely quoted valuation measure because it is simple, but it is only a starting point: the same P/E can be cheap for one company and expensive for another, and the earnings figure underneath it is often less solid than it looks.

Used carefully, the P/E helps you compare similar companies and ask the right question: what does the market expect this business to earn in future?

How it is calculated

A share trades at ₹900. The company earned ₹45 per share over the last twelve months.

P/E = ₹900 ÷ ₹45 = 20.

The inverse, earnings divided by price, is the earnings yield: ₹45 ÷ ₹900 = 5%. Earnings yield is sometimes easier to think about, because it can be set beside the interest rate on a deposit or a bond. It is not cash in your hand, though. The company keeps most of those earnings and pays out only part as dividends.

Trailing and forward P/E

Trailing P/E uses earnings actually reported over the past twelve months. It is based on fact but looks backwards.

Forward P/E uses analysts’ estimates of earnings for the coming year. It looks at what matters for the future but depends on forecasts that are often wrong, and usually wrong in the optimistic direction.

When you see a P/E quoted, check which it is. A company on a trailing P/E of 30 and a forward P/E of 20 is expected to grow earnings by half. If that growth does not arrive, the share is more expensive than it looks.

What a P/E actually reflects

A higher P/E means investors are willing to pay more for each rupee of current profit. They usually do that for one of three reasons:

• Expected growth. A company likely to double its profits in a few years can justify a high P/E today.
• Quality and stability. Steady, predictable earnings with little debt attract a premium.
• Low interest rates. When safe returns are low, investors accept lower earnings yields on shares.

A low P/E usually reflects the opposite: slow growth, uncertain or cyclical profits, high debt, or concerns about the business or its management.

One-off items distort the ratio

Reported earnings include items that will not recur: profit on selling a property, a large write-off, an insurance receipt, a tax adjustment. These can move the P/E sharply.

Back to the example. The ₹45 of earnings per share includes ₹10 per share of profit from selling a factory. Excluding that, the business earned ₹35 per share from its ongoing operations.

Illustrative figures.

A share that appeared reasonably priced at 20 times earnings is on nearly 26 times its recurring earnings. The reverse also happens: a one-off loss depresses earnings and makes the P/E look high for a company whose normal business is healthy. Read the notes to the results, or the company’s own explanation of exceptional items, before relying on the headline figure.

When a low P/E is not a bargain

Cyclical businesses. Companies in industries such as metals, cement or commodities earn the most at the peak of the cycle. Their P/E looks lowest exactly when profits are about to fall, and highest at the bottom when profits are depressed. For these companies, a low P/E can be a sign to be careful rather than to buy.

Declining businesses. A company losing market share may be cheap on today’s earnings and still expensive if those earnings shrink every year.

Heavily indebted companies. The P/E ignores debt. Two companies with the same P/E can carry very different risks if one has borrowed heavily. That is one reason analysts also look at measures based on enterprise value, which includes debt.

When a P/E cannot be used

If a company made a loss, the P/E is negative or shown as not meaningful. For young companies with little or no profit, other measures such as price to sales or cash flow are more informative, and valuation depends almost entirely on assumptions about the future.

How to use the P/E sensibly

1. Compare within an industry. A software company and a bank naturally trade on different multiples. Comparing their P/Es tells you little.
2. Compare with the company’s own history. A P/E well above its range over the past several years means expectations have risen. Ask whether the business has genuinely changed.
3. Relate it to growth. A P/E of 30 for a company growing earnings at 25% a year is a different proposition from a P/E of 30 for one growing at 5%.
4. Check the earnings quality. Remove one-off items, and check that operating cash flow broadly supports reported profit over several years.
5. Look at debt before concluding a share is cheap.

P/E for the whole market

Index providers publish the P/E of major indices. A market P/E well above its long-run average suggests that future returns may be lower than past ones, because investors are already paying more for each rupee of profit. It is a poor timing signal over months, since markets can stay expensive or cheap for years, but a reasonable input into long-term return expectations.

Where this fits

• Measuring what a share actually returned: stock return calculator
• The cash side of the return: dividend yield vs total return
• Reading the earnings behind the ratio: how to read a profit and loss statement
• Choosing between shares and funds: active vs index fund