Price-to-Earnings (P/E): What is the price relative to earnings?
The price-to-earnings (P/E) ratio is the share price divided by earnings per share. It is a ratio, not a forecast and not a buy recommendation.
Earnings per share is the profit attributable to ordinary shareholders divided by the relevant number of shares; reports may use a weighted average and also consider dilution. A historical P/E uses past earnings; a forward P/E uses an estimate that may change. When earnings are zero, you cannot divide by them. When the company is losing money, a negative P/E is not a standard measure of being “cheap.” Comparisons require similar companies, a consistent calculation method, debt, growth rate and earnings quality. One-off earnings can distort the ratio.
In a fictional company, the share price is 100 ₪ and the earnings per share in the year are 5 ₪: the P/E is 100 ÷ 5 = 20. If the price stays 100 and earnings fall to 2, the P/E rises to 50. This does not guarantee a return of the investment in 20 years.
Calculate the P/E for price 60 and earnings per share 3, and explain what we still do not know about the company.
Investor.gov · P/E ↗Check your understanding
Price 100 and earnings per share 5. What is the P/E?
- 5
- 20
- 500
Answer and explanation
20. 100 divided by 5 is 20.
Does a low P/E by itself prove you should buy?
- Yes
- No; you need to understand the business and the risk
- Yes, if it is below 10
Answer and explanation
No; you need to understand the business and the risk. A low P/E can be due to risk, expected earnings decline, or one-off earnings.
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How does one fund unit represent a basket of stocks? — A unit in a fund gives a proportional share of a fund that holds assets; it is not one share in each company.
How do company weights change an index? — An index can weight companies by market cap, price or equal weight. A large number of companies does not guarantee balanced diversification.
Two funds: Did we really diversify? — Different funds can hold the same companies. Check cumulative exposure, not just the number of funds.