What is price to earnings (P/E) ratio?

Another piece of fundamental analysis to help you assess the value of a share is a company’s price to earnings, or P/E ratio.

A P/E ratio is basically the amount investors are willing to pay for a share in a company, relative to its earnings.

Put another way, it shows how many years it would take for the company’s earnings to match the current price of its shares.

It is worked out by dividing the company’s current share price by its earnings per share.

Current share price ÷ earnings per share = P/E ratio

For example, a company whose shares are trading at $1 and has earnings per share of 10 cents has a PE ratio of 10.

• 100 (cents) ÷ 10 (cents) = 10

What do P/E ratios show?

Essentially a P/E ratio reflects the earnings potential of a company in the eyes of investors.

At first glance, a high P/E ratio suggests that investors believe it has high growth potential, whereas a low P/E ratio would indicate that growth is expected to be slow or non-existent.

Historical PE ratios vary from sector to sector and over time. The P/E ratio of the broad Australian share market has for the most part fluctuated between 10 and 20, with a long-term average of around 15.

When share markets and the wider economy are doing well, investors tend to be more confident about the future earnings potential of companies, causing P/E ratios to rise.

The opposite is likely to occur when economic conditions or share markets are not doing so well.

If you are considering buying shares in a company it can be useful to compare its P/E ratio to that of the broader market and particularly other companies in the same sector.

A company with a P/E ratio above all others in its sector could be considered to be expensive and one with a much lower P/E ratio could be considered cheap. Having said that, a higher P/E ratio may be a sign of a company with superior growth prospects.

A company’s current P/E ratio should be considered in conjunction with its previous and forward (projected) P/E ratio and broader financial performance and outlook, as well as that of its peers and the wider market.

What else to consider?

Different sectors tend to trade on very different levels of P/E ratios.

For example, slow growth industries like utilities and pharmaceuticals will typically carry low P/E ratios than faster growth industries.

Large, established companies that pay out a large portion of their earnings in dividends are also likely to have lower P/E ratios.