Price-to-Earnings Ratio (P/E)

What it is

The price-to-earnings ratio — almost always shortened to P/E — tells you how many pounds investors are paying for every pound of annual profit a company generates. If a share trades at 200p and the company earned 14p per share over the last twelve months, the P/E ratio is 14.3x. You're paying £14.30 for every £1 of earnings.

That's the entire maths. The complexity is in what it means.

How to calculate it

The EPS figure used matters. Trailing P/E uses the last twelve months of actual reported earnings. Forward P/E uses analyst consensus estimates for the next twelve months. Forward P/E is almost always lower — partly because markets are forward-looking, partly because analysts tend to be optimistic.

A third variant, cyclically adjusted P/E (CAPE), averages earnings over ten years to smooth out economic cycles. Robert Shiller popularised it for spotting market bubbles. It's not widely used for individual stock analysis in the UK.

What it actually tells you

A P/E ratio is a shorthand for how much growth investors expect. A stock on 8x earnings isn't necessarily cheap — it might reflect a business in secular decline, a heavily cyclical company near the peak of its cycle, or genuine concerns about earnings quality. A stock on 35x isn't necessarily expensive — it might be a compounder where earnings are growing 25% per year.

The ratio only makes sense in context:

• Versus the market: The FTSE 100 has historically traded between 12–18x earnings. A FTSE 100 stock on 25x needs a story.
• Versus sector peers: Banks typically trade on 7–10x. Software companies on 25–50x. Comparing a bank to a tech firm by P/E is like comparing a sprinter's time to a marathon runner's pace.
• Versus its own history: If Unilever has averaged 20x earnings for twenty years and currently trades at 14x, that's potentially interesting. If it usually trades at 14x and is at 20x, that needs justifying.

The classic trap

High P/E doesn't mean overvalued. Low P/E doesn't mean cheap. This is the most common mistake retail investors make with this ratio.

In 2020, Rolls-Royce had an essentially unmeasurable P/E because it was losing money. Its valuation still had meaning — just not through this lens. By 2023, as earnings recovered, the P/E compressed dramatically even as the share price tripled, because earnings grew faster than the price.

The P/E also breaks down entirely for companies that are loss-making, for banks and insurers (where book value matters more), and for highly cyclical businesses at the peak or trough of their cycle.

Using it well

The most useful application is spotting P/E compression and expansion. A company trading at 15x that re-rates to 20x has delivered 33% upside purely from multiple expansion, even if earnings haven't moved. Understanding why markets assign a particular multiple to a business — and whether that's justified — is the core craft of equity analysis.

For practical UK stock analysis, compare the trailing P/E to the stock's five-year average multiple, the sector median, and the FTSE 100 average. If all three are pointing the same direction, you have something worth investigating further.

All ratios are illustrative. Not financial advice.