What is PE Ratio? - Explained for Beginners
The Price-to-Earnings Ratio (P/E ratio) is one of the most widely used tools in investing. It gives investors a quick snapshot of how expensive (or cheap) a stock might be compared to its earnings.
But what exactly is it? How do you calculate it? And is it actually a good measure of value? Let’s break it all down.
What Is the P/E Ratio?
In simple terms, the P/E ratio tells you how much investors are willing to pay for £1 of a company’s earnings.
The formula is straightforward:
P/E Ratio = Price per Share ÷ Earnings per Share (EPS)
EPS (earnings per share) can easily be found on most stock summary pages.
Example:
Stock Price = £50
Earnings per Share (EPS) = £5
P/E Ratio = £50 ÷ £5 = 10
This means investors are paying £10 for every £1 that the company earns.
Why Does the P/E Ratio Matter?
The P/E ratio is a quick way to get a sense of valuation:
High P/E Ratio: Investors are paying more for each £1 of earnings. This could mean the stock is overvalued, but it might also mean investors expect strong future growth.
Low P/E Ratio: Investors are paying less for each £1 of earnings. This could mean the stock is undervalued, but it might also mean the company has weak growth prospects or faces risks.
So while the P/E ratio can be useful, it should never be the only factor you use when analysing a stock.
How to Use the P/E Ratio Effectively
Here are three key tips to avoid common mistakes:
1. Look at Historical P/E Ratios
Check how a company’s P/E has changed over the past 5–10 years. If the ratio is currently much higher than its historical average, it may suggest the stock is expensive compared to its past.
2. Compare Within the Same Industry
A P/E ratio only makes sense when compared to similar companies.
Tech stocks, for example, often trade at much higher P/E ratios than banks or utility companies.
This doesn’t automatically mean tech is overpriced or banks are cheap, it just reflects different growth expectations.
3. Combine P/E with Other Metrics
Never rely on P/E alone. Combine it with other measures like:
PEG ratio (P/E adjusted for growth)
Debt levels
Profit margins
Industry trends & risks
Using multiple tools together gives you a much clearer picture of whether a stock is a good buy.
Is the P/E Ratio a Good Measure of Value?
The short answer: it’s helpful, but limited.
Strengths: Quick, easy, and widely used.
Weaknesses: Doesn’t account for growth potential, debt, or industry differences.
Think of it as a starting point, not the full story. It’s best used in combination with other tools to judge whether a stock is undervalued or overvalued.
Final Thoughts
The P/E ratio is a great way to get a fast sense of how a stock is valued. But it should always be used alongside other metrics and industry comparisons.
If you’re a beginner investor:
Start by comparing P/E ratios between companies in the same sector.
Then layer in other data (growth, debt, margins) before making a decision.
Used correctly, the P/E ratio can be a powerful part of your investing toolkit.
This is NOT financial advice. This content is for educational and entertainment purposes only. Investing involves risk, and your capital is at risk. Past performance is not a guarantee of future results. The information in this blog was accurate at the time of posting.
