Finance⏱ 5 min read
What Is the Price-to-Earnings Ratio (P/E) and How Do You Use It?
The P/E ratio is one of the most widely quoted valuation metrics — and one of the most frequently misunderstood. Here's what it actually tells you, its limitations, and which variations matter more.
The price-to-earnings (P/E) ratio compares a company's share price to its earnings per share. It's the most common starting point for stock valuation — but a single P/E number tells you less than most investors think.
The Basic Calculation
P/E Ratio = Share Price / Earnings Per Share (EPS)
EPS = Net profit / Number of shares outstanding
Example: Company share price £25
Net profit last year: £50 million
Shares outstanding: 100 million
EPS = £50m / 100m = £0.50
P/E = £25 / £0.50 = 50
This means investors are paying 50x last year's earnings.
Or: at current earnings, it would take 50 years for the company
to earn back its current market value.
Trailing P/E vs Forward P/E
Trailing P/E: uses last 12 months' actual earnings (backward-looking)
Forward P/E: uses analyst forecasts for next 12 months (forward-looking)
These often differ significantly:
If earnings are expected to grow 30% next year:
Trailing P/E: 50
Forward P/E: 50 / 1.30 = 38.5
High trailing P/E but low forward P/E = market expects
high earnings growth — justified premium if growth materialises.
The opposite (low trailing, high forward P/E) signals
expected earnings decline — a warning sign.
What P/E Tells You — and Doesn't
P/E RangeTypical InterpretationCaveat
Below 10Cheap / value stockMay be cheap for a reason (declining business)
10-20Moderate valuationDepends heavily on sector and growth rate
20-40Growth premiumJustified if earnings growing 20%+/year
40-100High growth expectationsRequires sustained high growth to justify
Negative P/ECompany losing moneyP/E is meaningless — use other metrics
The PEG Ratio: Correcting for Growth
PEG = P/E Ratio / Annual EPS Growth Rate (%)
A P/E of 40 at 40% growth = PEG of 1.0
A P/E of 40 at 10% growth = PEG of 4.0
Peter Lynch's rule of thumb:
PEG below 1.0: potentially undervalued relative to growth
PEG above 2.0: potentially overvalued relative to growth
This fixes the main problem with P/E alone — it penalises
fast-growing companies that look "expensive" by P/E but are
actually reasonably priced relative to their growth trajectory.
Cyclically Adjusted P/E (CAPE / Shiller P/E)
CAPE = Current Price / Average Inflation-Adjusted EPS (10 years)
Removes single-year earnings distortions from recessions or booms.
Better for assessing overall market valuation.
S&P 500 CAPE historical averages:
Long-term average: ~17
Pre-1990s: 10-20 range
1999 peak (dot-com bubble): 44
2009 trough: 13
2025: approximately 35-38
Above 30 has historically been followed by below-average
returns over the next 10-year period (not a timing signal,
but a realistic expectations-setter).