The Price to Earnings Ratio (PE) is an evaluation ratio of a company’s current share price compared to its per-share earnings. It is also known as “price multiple” or “earnings multiple”.
It is calculated as:
(Share Price) / (Earnings per Share (EPS))
For example, if a company is currently trading at $56 a share and earnings over the last 12 months were $1.50 per share, the P/E ratio for the share would be 37.33.05 ($56/$1.50).
The EPS used is usually from the last four quarters (trailing P/E), or sometimes it can also be based on the estimates of earnings expected in the next four quarters (projected or forward P/E). Another variation uses the sum of the last two actual quarters and the estimates of the next two quarters.
Generally, a high PE suggests that investors are expecting higher earnings growth in the future compared to companies with a lower PE. Note, the P/E ratio doesn’t tell us the whole story. It’s usually more useful to compare the PE ratios of one company to other companies in the same industry or sector, to the market in general or against the company’s own historical PE. The PE should not be used as a basis for investment to compare the PE of a technology company (high PE) to a utility company (low PE) as each industry has much different growth prospects and business models.
PE is also referred to as the “multiple”, because it shows how much investors are willing to pay per dollar of earnings. If a company were currently trading at a multiple (PE) of 16, the interpretation is that an investor is willing to pay $16 for $1 of current earnings (profit).
There is one problem to note with the PE measure – the denominator (EPS) is based on an accounting measure of earnings that is susceptible to forms of manipulation, making the PE only as good as the quality of the underlying earnings number.