Lesson 03 of 04
The price-to-earnings ratio
P/E divides price by earnings. It tells you the multiple. It does not tell you what to do.
Keep these
- P/E = price per share ÷ earnings per share.
- The same math is market cap ÷ total earnings.
- A low multiple can mean a bargain, a failing business, or a strange year.
The lesson
Once earnings are stated per share, you can divide the share price by that figure. A P/E of 10 means the price is ten times those earnings. Equivalently, divide the whole market capitalization by the company’s earnings. Both versions fail in the same way when earnings are zero or negative: the ratio stops being a useful scale.
Always ask which earnings. Trailing earnings look backward, often over the last twelve months. Forward earnings are someone’s forecast. A ratio built on a forecast is only as calm as the forecast. A ratio built on last year says nothing about a contract the company might lose next spring.
Comparisons need a peer group and a story. A utility and a young software firm can carry different multiples for reasons that have nothing to do with which one is “on sale.” Use P/E as a question — what is the market paying for each unit of recent profit? — and stop before it becomes an instruction.