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Price Earnings Ratio: P/E ratio

The P/E ratio is a vital ratio for investors. Basically, it gives us an indication of the confidence that investors have in the future prosperity of the business. A P/E ratio of 1 shows very little confidence in that business whereas a P/E ratio of 20 expresses a great deal of optimism about the future of a business.

Here's the formula, then we'll work through an example

Here are the P/E ratios of five businesses in the Telecommunications sector:

Source: The Times Newspaper 18 September 2002

See how big some of these P/E ratios are - that's not necessarily a good thing! Let's look at the calculations and then we can interpret our findings.

Again, we need current market share prices as well as the EPS values. This means we can go back to the Carphone Warehouse even though it isn't paying dividends at the moment:

Note:

1. the current market share price is taken from The Times newspaper 18 September 2002 and the EPS is taken from the table below (previously calculated in the EPS section, above)
2. we have worked in pence here; but we could just as easily have worked in Pounds and the answer would have been the same, at a P/E ratio of 16.52

What does a P/E ratio of 16.52 mean? In raw terms it means that investors are currently paying the equivalent of 16.52 years' worth of earnings to own a share in the Carphone Warehouse. That is, they hare currently paying 76 pence per share and since the EPS is 4.6 pence per share, this means that they will recover their investment in a share after 16.52 years - equivalent to the break even and payback period if you like.

16.52 is a high value for a P/E ratio; but not the highest and essentially the higher the ratio the better. However, we would say that P/E ratios of 78.4 and 48.4 are excessive and might reflect an unreal situation. It's possible in extreme circumstances that the share price is, in fact, independent of the current market share price so that a high P/E ratio is actually based on more up to date news than last years EPS value.

BT has a P/E ratio of 48.4 yet it is not too long ago that it was heading for potential liquidation as its victory in securing its third generation licences had led to its taking on a massive debt burden that it could not, in reality, sustain. However, it seems now that investors like the current performance of BT and are voting for it by buying its shares at highly inflated values relative to its EPS.

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