The price to earnings ratio (P/E) is calculated by dividing the price per share of a company by its earnings per share. The earnings per share part of the equation is derived by dividing the earnings of a company by the total number of outstanding shares.
This ratio is useful for helping investors to ascertain the ‘value’ of a stock, whether it is currently ‘cheap’ or ‘expensive’ in the market. It does so by comparing the share price of a company to its profits. A P/E ratio of 20 means that a company is trading at 20 times its earnings – or that an investor is willing to pay £20 for every £1 of earnings generated.
Typically, a lower P/E ratio is a better sign than a higher P/E ratio – this is because a lower P/E ratio shows that a company could be undervalued. Investors who use the P/E ratio as part of their share identification process commonly deploy a maximum criteria of a 20x P/E ratio. Whilst a P/E ratio of 20 is usually the standard threshold, investors should also compare the P/E ratio to the respective industry median.
The PEG ratio further builds on the P/E ratio by incorporating the growth forecast of a company into analysis.