What Is the P/E Ratio and How Can You Use It? (With Example)

Updated 21 May 2023

The price-earnings (P/E) ratio is a good indicator of a business's success and investment potential. Knowing the P/E ratio of a business's shares can help you decide if you want to connect with the company. Your knowledge can help you make better decisions for your career and investments. In this article, we explain what the P/E ratio is and how to use it, with an example.

What is the P/E ratio?

The P/E ratio is short for the price-earnings or price to earnings ratio. This ratio measures the relationship between a business's current share price and its annual earnings per share. This ratio is sometimes called the price multiple or earnings multiple.

What the price to earnings ratio shows

The price to earnings ratio shows how much an investor may pay for a stock for every dollar the company earns. It reflects a company's earnings potential according to investors. People who buy stocks with low price to earnings ratios pay less for each dollar of a business's earnings than people who buy stocks with high price-earnings ratios. The ratio shows a business's place in the share market. Investors can also use the price to earnings ratio as a tool to suggest whether investors overvalue or undervalue a company's shares.

A high P/E shows a business's share price has increased faster than the company's share earnings. When the price-earnings ratio is high, investors can expect high dividends for their investment in the short term. A low price compared to earnings shows the share price has dropped faster than the company's share earnings. Companies with low P/E ratio stocks often grow slowly, remain steady or decline. While investing in companies with a low P/E ratio can be riskier than investing in businesses with high P/E ratios, the risks can pay off in time.

What is a good P/E ratio?

What is considered a good P/E ratio depends on the current financial market. A poor P/E ratio today may be considered good six months from now if there is an economic downturn. Price to earnings ratios usually rise when share markets and the economy flourish and fall during challenging economic and share market conditions. You can assess if a business's P/E ratio is good by comparing it to the ratios of other companies, especially those in the same industry.

Whether a ratio is good also depends on your goals. If you want to make a financial investment in a company, you may have different criteria. Some traders prefer investing in companies with high P/E ratios, as this indicates high future growth is likely. Others prefer investing in companies with low P/E ratios. As future growth is less likely, these riskier investments can pay larger dividends if they perform better than expected. As a general rule, investors typically invest in companies with P/E ratios higher than five, as a ratio below five suggests it's very likely the business has a poor future.

Why use the P/E ratio?

The P/E ratio provides an easy way to compare companies. Financial publications commonly print the P/E ratio, so you can see at a glance how companies compare to one another. This approach is much more efficient than analysing different business's financial statements. Filtering businesses by their shares' P/E ratios is a good way to create a short-list of investment or employment options.

Related: How to Become a Stockbroker: The Ultimate Guide

How to use the P/E ratio

The P/E ratio is commonly used to value shares. Investors, including investment analysts and investment bankers, may use this ratio to compare investment options. The P/E ratio is also a good tool for comparing employers during your job search, as this figure indicates a company's financial stability. You could also track your employer's ratio to understand the company's financial prospects. Here are the common steps for using a P/E ratio:

1. Find the P/E ratio

You can often find a company's P/E ratio by searching for it online. You can also calculate the ratio yourself by dividing the share price by the company's annual earnings per share. You can find a company's share price by searching for the business on the Australian Stock Exchange (ASX). You can find its earnings per share in the company's annual report posted on the ASX website.

For example, a business currently trades at $14 per share. Its annual earnings in the last year are $1.12 per share. Dividing 14 by 1.12 tells you the price to earnings ratio for the business's shares is 12.5.

2. Compare P/E ratios

Comparing P/E ratios gives them context. You can compare P/E ratios to other P/E ratios of the time to assess a company's standing in the market. Comparing a business's P/E ratios to the P/E ratios of its industry competitors can help you evaluate current market performance.

You could also compare a business's P/E ratios over time. Comparing a business's current P/E ratio with its P/E ratios in previous financial quarters is a good way to track its performance over time. While investors care more about future potential than past earnings, past performance can be a good indicator of future success.

3. Assess what the P/E ratio tells you

Analysing P/E ratios provides information you can use to make smarter decisions about your investments or career. When comparing P/E ratios within the same industry, investors often invest in companies with lower P/E ratios as they may get undervalued. If these companies perform better than expected, their shares can earn large dividends. You may track the P/E ratios of your investments over time. If you have shares in a company with very high P/E ratios, you may decide to see if it continues increasing or sell. The high ratio can indicate the shares are volatile and may decrease in value.

Companies with shares with medium to high P/E ratios are often good options for employees and people searching for new jobs. Medium P/E ratios indicate reasonable financial performance and stability. High P/E ratios show significant growth. The P/E ratio may fall over time when growth subsides, but so long as it stays in the medium range the company is probably financially sound. If the business's P/E ratio falls to a very low level, you may consider searching for another job at a more stable business.

Related: What Does a Stockbroker Do? (Full Career Guide With Salary)

4. Consider other factors impacting the share value

Considering if other factors are impacting the value of shares can help you assess if the company's earnings are sustainable. For example, a heatwave may increase the value of a surf brand's shares. The company's high P/E ratio may fall quickly as the temperature subsides. In contrast, a shift towards flexible and remote working conditions may create more sustainable earnings for a video conferencing company. A business's upcoming product releases, technological developments and predicted personnel changes can also impact its stock value and P/E ratios.

Related: What Is Continuous Improvement? With Benefits and Models

5. Act on your assessment

After considering a variety of factors including the P/E ratio of the business's stock, you may feel more confident making decisions. Analyse all information you have available and use your best judgement to make a decision. While your decision probably carries some degree of risk, you are more likely to make a wise investment or career move after considering all your options, including the P/E ratio.

Related: Decision-Making Skills: Definition With Tips

P/E ratio example

The following is an example of using the P/E ratio to assess the value of a business's shares:

Dale is a day trader who wants to expand their portfolio into the fitness space. They are considering buying shares in Sweat it Out Sports or Serene Yoga Goods. Dale uses the P/E ratio to assess their options. They browse a financial website and notice Sweat it Out Sports has a P/E ratio of 13.78 while Serene Yoga Goods has a P/E ratio of 25.16. Dale adds up the P/E ratios of all fitness companies listed on the website and divides this sum by the number of fitness companies to find the fitness industry's average P/E ratio is 15.

Dale decides to invest in Sweat it Out Sports. As this company's P/E ratio is slightly below the industry average, they feel the company is relatively financially stable. They believe investors are undervaluing the company and it could be a good long-term investment. They also feel investors may overvalue Serene Yoga Goods and its shares may decrease if a different workout trend overtakes yoga. While Serene Yoga Goods could pay high dividends, Dale decides Sweat it Out Sports is the best current investment option.

Please note that none of the companies, institutions or organisations mentioned in this article are affiliated with Indeed.

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