The price-earnings ratio values a share by comparing a company’s share price to its per-share earnings. It is used to measure the relative cost of a share as it illustrates how much money the investor has to pay for each €1 of the company’s earnings.

The price-earnings ratio (P/E ratio), which is also sometimes known as ‘price multiple’ or ‘earnings multiple’, is calculated by dividing the current market value per share by the earnings per share (EPS):

While the current market value of the share is its currently quoted share price, earnings per share are calculated by dividing the annual net income by the number of shares outstanding.

For example, if a company’s share is currently trading at €45 and earnings for the last 12 months equate to €5 per share, it will result in a P/E ratio of 9.

In other words, the investor had to pay €9 per share for every €1 of the company’s per share earnings.

Interpretation

However, there are different ways to interpret what the P/E actually means. The share price of a company will not only include historic information but also future expectations. This means that the P/E ratio can also be interpreted as a reflection of market expectations for the company’s growth prospects.

In this sense, a high P/E would indicate that investors expect higher earnings growth in the future. Eventually the company will have to increase earnings to justify the high and rather expensive ratio or the share price will fall. Conversely, a low P/E may represent a lack of investor confidence in the share or simply a share that is undervalued.

It is important to remember though, that P/E ratios differ between industries. When P/E ratios are compared, it should be between companies of the same industry, the industry average or the company’s past P/E values.

The difficulty in interpreting the P/E is not due to the complexity of the share price alone. As the denominator of earnings per share is based on an accounting measure of earnings, the figure may be open to manipulation. In addition, there are different types of P/E ratio in use.

Typically, the P/E is calculated by using earnings per share (EPS) from the last 12 months, which is then known as the trailing P/E. The projected P/E is based on estimated EPS for the next 12 months. A third variation uses a mixture of historic EPS (last two quarters) and estimated EPS (following two quarters). Earnings estimations are of course, not necessarily correct and the reliability of the P/E is only as good as the underlying earnings projections.

Because the P/E ratio is open to many interpretations, it should be used in conjunction with other indicators, such as the company’s history of generating earnings and how predictions for future growth fit into this picture. As part of a bigger picture, the P/E ratio is a much more reliable indicator of relative cost than the share price and the trend of the share price on its own.