Price to Earnings Ratio (P/E)

The price to earnings ratio, or P/E, is figured by dividing the stock price by the company’s earnings per share (EPS). The P/E is a performance benchmark that can be used as a comparison against other companies or within the stock’s own historical performance. For instance, if a stock has historically run at a P/E of 35 and the current P/E is 12, you will want to explore the reasons for the drastic change. If you believe that the ratio is too low, you may want to buy the stock.

You will generally find a P/E ratio based on either the prior reporting year’s earnings, or the earnings of the prior four quarters added together. This latter number is referred to as LTM or Latest Twelve Months. While this is useful for understanding the history of a company, most analysts prefer to view a forward-looking P/E ratio. This ratio is calculated by dividing the stock price by the analysts’ earnings estimate for the next year or two.

One other note on P/E Ratios – sometimes, when a company is not doing well, it will buy back shares so that the EPS and P/E Ratio will appear better. This can be seen in the example below.

Example 1

Example 2

Net Income

£1,000,000

£1,000,000

Shares Outstanding

10,000,000

8,000,000

Earnings Per Share (EPS)

£0.10

£0.125

Stock Price

£3.00

£3.00

P/E Ratio

30

24

In the table above, the only change from Example 1 to Example 2 is in the number of shares outstanding. The net income and stock price remain the same. However, by changing the shares outstanding, the EPS has changed quite a bit. This means that the P/E ratio has also changed. At first glance, if a stock’s EPS has increased 25% and its P/E ratio has gone from 30 to 24 it might look like a better buy. However, the truth is that nothing has changed but the number of shares. The stock is not a better buy in Example 2 than it was in Example 1.