Lesson 2 of 12 · 3 min · Valuation

The P/E ratio

How many years of profit the price buys you.

1. The price to earnings ratio, or P/E, divides the share price by the profit per share. It is the most quoted number in investing.

2. Lemon Co made a profit of $1.5 million last year. Spread over 1 million shares, that is $1.50 per share. At $30 a share, the P/E is 20.

3. One way to picture it: if profits stayed exactly the same, it would take 20 years of Lemon Co’s earnings to pay back what you paid.

4. Turn it upside down and you get the earnings yield: $1.50 divided by $30 is 5%. That makes it easy to compare with the interest on savings or bonds.

5. Lower means cheaper: you pay less for each dollar of profit. But a high P/E is not bad on its own. It usually means buyers expect profits to grow. A low one can be a bargain, or a business in trouble.

6. What counts as high? Since 1871, the US market has averaged a P/E of about 16. In recent years it has mostly sat above 20. Fast growing industries usually carry higher P/Es, so compare with rivals too.

7. Watch out for odd years. A one off gain or loss makes the profit jump, and the P/E with it. Look at several years before you trust it.