The P/E ratio explained, with the arithmetic shown

What is the P/E ratio?

The P/E ratio, or price-to-earnings ratio, is a share's price divided by its earnings per share. It tells you how many rupees people are paying today for each one rupee of the company's yearly profit per share.

If a share's P/E is 15, buyers at today's price are paying Rs 15 for every Rs 1 of yearly profit that belongs to one share. It is a way to compare price with profit, instead of looking at price alone.

Why not look at price alone? Because a share priced at Rs 50 is not automatically "cheaper" than one priced at Rs 500. What matters is what you get for that price. The P/E ratio is one simple way to relate the two. If you are new to shares, read stock market basics first.

First, EPS: earnings per share

EPS is the company's net profit divided by its number of shares. It is the profit that belongs to each single share, and it is the "E" in P/E.

In our lesson on how to read quarterly results, made-up ABC Limited earned a net profit of Rs 150 crore in one quarter and had 50 crore shares. So its EPS for that quarter was Rs 150 crore divided by 50 crore, which is Rs 3.00.

For P/E, people normally use a full year of EPS, not one quarter. Suppose ABC's EPS for its last four quarters was Rs 3.00, Rs 3.26, Rs 2.90 and Rs 2.84. Add them: 3.00 plus 3.26 plus 2.90 plus 2.84 is Rs 12.00. That is ABC's EPS for the trailing twelve months, often written TTM.

EPS is reported by the company in its results. You can calculate it yourself as a check, but the company's figure takes care of details such as changes in share count during the year.

How to calculate P/E: ABC Limited and XYZ Foods

Divide the share price by the yearly EPS. ABC Limited at Rs 180 with EPS of Rs 12 has a P/E of 15. XYZ Foods at Rs 450 with EPS of Rs 15 has a P/E of 30.

Both companies are made up. Here is the arithmetic, step by step.

• ABC Limited: price Rs 180, yearly EPS Rs 12. 180 divided by 12 is 15. P/E is 15.
• XYZ Foods: price Rs 450, yearly EPS Rs 15. 450 divided by 15 is 30. P/E is 30.

You can reach the same answer from the whole company. ABC has 50 crore shares at Rs 180 each. 50 crore times 180 is Rs 9,000 crore. That total is called market capitalisation, or market cap. ABC's net profit over the last year was 50 crore shares times Rs 12, which is Rs 600 crore. Rs 9,000 crore divided by Rs 600 crore is 15. Same P/E.

Another way to see it is to flip the ratio. 1 divided by 15 is about 0.067, or 6.7%. This is called the earnings yield: ABC's yearly profit is about 6.7% of its market cap. XYZ's is 1 divided by 30, about 3.3%.

Notice that XYZ Foods has the higher share price and also the higher P/E, but those two facts are not linked. A Rs 450 share could just as well have a P/E of 8. Price alone tells you nothing about P/E.

Trailing P/E vs forward P/E

Trailing P/E uses profit the company has already reported over the last twelve months. Forward P/E uses an estimate of profit for the coming year. Trailing is based on facts; forward is based on someone's guess.

ABC's trailing P/E is 15, from the actual EPS of Rs 12. Now suppose some analysts estimate ABC's EPS for next year at Rs 14. The forward P/E is 180 divided by 14, which is about 12.9.

The forward number looks lower, but it rests on an estimate. If ABC's profit falls short and EPS comes in at Rs 10 instead, the P/E on that actual profit is 180 divided by 10, which is 18. Estimates are opinions about the future and they are often wrong. When you see a P/E on a website, check whether it is trailing or forward, and whose estimate it uses.

Why a low or high P/E alone says nothing

A low P/E does not mean a share is a bargain, and a high P/E does not mean it is too costly. The number only tells you how price compares with past or expected profit, not why.

A P/E can be low because people expect profit to shrink, because the company carries heavy debt, because its profit came from a one-off gain, or because of worries that may or may not prove right. A P/E can be high because people expect profit to grow fast, or simply because of excitement. In each case the ratio is a starting point for questions, not an answer.

One-off items matter here too. If a company books a large one-time gain, its EPS jumps for that year and its P/E drops sharply, even though nothing lasting changed. That is why reading the results, as explained in how to read quarterly results, comes before trusting any ratio.

Prices and profits both change all the time, so a P/E changes too. Any investment in shares can lose money, whatever its P/E.

Compare within the same industry only

P/E comparisons make most sense between similar companies in the same industry. Different industries grow, spend and earn in different ways, so their typical P/E levels differ a lot.

Comparing ABC Limited, a mobile company, with XYZ Foods, a snacks company, says very little. A mobile network needs huge spending on towers and spectrum. A snacks company has very different costs, risks and growth. The two P/E numbers are measuring different kinds of business.

A fairer comparison would be ABC with another made-up mobile company, or XYZ Foods with another made-up snacks maker, over the same period and using the same kind of P/E (both trailing, both consolidated). Even then, a gap in P/E is a question to investigate, not a conclusion.

What about loss-making companies?

If a company made a loss, its EPS is negative, and the P/E ratio has no useful meaning. Many websites show it as blank or "not applicable".

Take a made-up company, PQR Motors. Its share price is Rs 120, and last year it lost Rs 4 per share. 120 divided by minus 4 gives minus 30. A negative P/E cannot be compared with positive ones, so it is ignored. People looking at loss-making companies use other measures, such as revenue growth or how much cash the company has left. Those come with their own limits.

A company with very small profit can also show a huge P/E. If PQR earned just Rs 0.50 per share, its P/E would be 120 divided by 0.50, which is 240. That number reflects tiny profit more than anything else.

Other ratios in brief: P/B and dividend yield

Price-to-book (P/B) compares price with the company's net assets per share. Dividend yield compares the yearly dividend with the share price. Like P/E, each is one view, never the whole story.

• P/B: book value is what the company owns minus what it owes, as shown in its accounts. Suppose ABC's book value is Rs 4,500 crore. Divided by 50 crore shares, that is Rs 90 per share. P/B is 180 divided by 90, which is 2.
• Dividend yield: suppose ABC paid dividends of Rs 3.60 per share over the last year. 3.60 divided by 180 is 0.02, so the dividend yield is 2%. Dividends are never promised and can be cut or stopped.

Common mix-ups

The usual P/E mistakes are mixing trailing with forward figures, comparing across industries, and treating a low P/E as a signal to buy.

1. "Low P/E means cheap." It may mean people expect profit to fall. The ratio does not tell you which.
2. "P/E uses one quarter's EPS." Normally it uses a full year. Using one quarter would make the P/E look roughly four times larger.
3. "A higher share price means a higher P/E." No. P/E depends on price and EPS together.
4. "P/E changed, so the company changed." P/E moves every time the price moves, even if the business is the same. After a bonus or split, both price and EPS adjust, so P/E stays about the same. See dividends, bonus issues and splits.

Check yourself, and where to check

Three quick questions, then the primary sources to read real figures yourself.

1. A made-up share costs Rs 240 and its yearly EPS is Rs 16. What is its P/E?
   Answer: 240 divided by 16 is 15.
2. If that EPS is an estimate for next year, which kind of P/E is it?
   Answer: forward P/E.
3. A company lost money last year. Can you compare its P/E with ABC's?
   Answer: no. A negative EPS makes the P/E meaningless for comparison.

Where to check: EPS appears in each company's results filed on the NSE website and the BSE website. The SEBI investor website has free material on reading company information. For how investors look at ratios in general, see fundamental vs technical analysis.