ValuationBeginner· 9 min read

The P/E ratio, and how it lies to you

The one thing to remember

A P/E is a sentence about expected growth, not a verdict on cheapness.

The price-to-earnings ratio is the most quoted number in investing, and the most abused. It is not a verdict on whether something is cheap. It is a sentence about what the market expects, and like any sentence it can be a lie.

What it measures

P/E = share price ÷ earnings per share

Equivalently: market cap divided by total annual profit.

A P/E of 20 means you are paying £20 for every £1 the company earns in a year. Put another way, at today's profits it would take twenty years of earnings to pay you back. That framing is the useful one, because it makes the assumption visible: at today's profits. Nobody buys a company expecting profits to stand still.

What a P/E is actually sayingInteractive

Share price40 £

Earnings per share2 £

Expected growth10%

P/E ratio

20.0

Years of earnings you pay

20 yrs

Payback allowing for growth

12 yrs

Ordinary. The market expects steady, unremarkable growth.

The P/E is years of today's earnings you are paying. Growth shortens the payback, which is why fast growers deserve higher multiples.

Why growth changes everything

A company growing earnings at 25% a year doubles its profits in three years. The P/E you pay today is measured against earnings that are about to be much larger. That is why a high multiple can be entirely rational, and why a low one can be a trap.

A P/E is not a price tag. It is a bet on the growth rate, expressed as a number.

PEG ratio

Divide the P/E by the expected growth rate. A P/E of 30 on 30% growth gives a PEG of 1.0. Below 1 is often considered attractive. Treat it as a rough sanity check rather than a law: it is only as good as the growth forecast fed into it, and growth forecasts are usually optimistic.

The three situations where it lies

1. The value trap

A P/E of 6 looks like a bargain. Sometimes it is. Often it means the market has correctly worked out that earnings are about to fall off a cliff, and the "E" in the denominator is a number that will not exist next year. Cheap on collapsing earnings is not cheap. It is expensive, arriving slowly.

2. The cyclical inversion

For cyclical businesses (miners, carmakers, chemicals, housebuilders) the P/E works backwards. At the top of the cycle profits are enormous, so the P/E looks tiny, and that is precisely the worst moment to buy. At the bottom, profits have vanished, the P/E looks absurd or is negative, and that is often the best moment. Learn to invert your instinct here.

3. The accounting mirage

Earnings are an opinion produced by accountants under rules with a great deal of latitude. Depreciation schedules, one-off charges, capitalised costs and share-based compensation all bend the "E". Two companies with identical economics can report visibly different profits. This is why the cash flow statement is the honest one.

No earnings, no P/E

A loss-making company has no meaningful P/E at all. Screeners often display a blank, or a nonsense number. Absence of a P/E is not a sign of cheapness. It is a sign you need a different tool, usually price-to-sales or a DCF.

How to use it properly

Compare a company to its own history, and to its direct competitors. A P/E means nothing in isolation.
Ask what growth rate the multiple implies, then ask whether that is plausible. This is the single most useful question in valuation.
Cross-check against cash. If profits rise while operating cash flow does not, be suspicious of the E.

In SteadyShares

Every stock page shows the P/E against the sector average, and the Compare tab puts it side by side with rivals, which is the only way the number means anything.