P/E ratios made simple

By THIS IS MONEY
Updated:

 

How is a P/E [price to earnings ratio] calculated? Is it better for a company to have a high P/E or a low one? Answer in plain English please. DS, Cheltenham.

Terry Bond a director of Proshare, the organisation devoted to promoting share ownership, says: The P/E ratio is the market price of a share divided by its earnings per share over the latest 12-month period.

Whether it is better to have a high or low P/E depends on the sector a company is in and the potential that market sees in the company.

For example, at present an internet stock, where the likely profits are in the future rather than now, could show a high P/E because current earnings are low but the share price is high. The ratio is only one indicator of a company's worth but should never be taken in isolation when deciding whether to buy a share or not as there are so many factors that can affect it.

On the other hand, for a well-established company the P/E can be a measure of whether a share is over or undervalued. A high P/E where the price is higher than the earnings can indicate that it is an expensive share whereas a low P/E could indicate that the market does not currently think much of it. What is more if a sector is out of favour you will see relatively low P/Es even on companies that otherwise would be valued highly. In total you can use P/E to compare an individual share with the rest of the sector but don't forget to look at the sector in comparison with the rest of the market and always use P/Es in combination with other indicators.

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