Price-to-Earnings Ratio (P/E)

The Price-to-Earnings Ratio (P/E) (also known as the 'P/E Ratio' or 'earnings multiple') is one of the most famous metrics in the investing world. Think of it as a price tag that tells you how much investors are willing to pay for every dollar of a company's profit. The calculation is simple: you take the company's current Share Price and divide it by its Earnings Per Share (EPS). For example, if a company's stock trades at €20 and its annual earnings per share are €2, its P/E ratio is 10 (€20 / €2). In essence, you are paying €10 for every €1 of the company's current earnings. This simple number is the starting point for countless investment stories, helping investors quickly gauge whether a stock is 'expensive' or 'cheap' relative to its earnings power. However, like any good story, the P/E ratio has layers of meaning, and a savvy value investor knows how to read between the lines.

In a very simplified world, a P/E of 10 suggests that if the company paid out all its earnings as dividends, it would take you 10 years to get your initial investment back. Of course, companies rarely do this—they reinvest profits for growth. Still, it’s a powerful mental model for understanding the price you're paying.

A high P/E ratio often signals that the market has high expectations for the company's future growth. Investors are willing to pay a premium today for anticipated higher earnings tomorrow. A low P/E might mean the market is pessimistic, or it could be an overlooked gem—the kind of company value investors love to find.

A P/E ratio is useless in a vacuum. Its power comes from comparison. But be careful what you compare it to!

• Industry Peers: A software company with a P/E of 30 might be considered cheap, while a utility company with a P/E of 20 could be seen as wildly expensive. Different industries have different growth prospects, capital requirements, and risk profiles, leading to different average P/E ratios. Always compare a company's P/E to its direct competitors.
• Its Own History: How does the company's current P/E compare to its own 5-year or 10-year average? A P/E that is significantly lower than its historical average might signal a buying opportunity, assuming the underlying business fundamentals haven't deteriorated.

The “Price” is easy—it's public and updated every second. The “Earnings,” however, can be tricky. You need to know which “E” you are looking at.

• Trailing P/E (TTM): This is the most common type. It uses the earnings per share from the last four quarters, or Trailing Twelve Months (TTM). It’s based on actual, reported performance, which is good. The downside? The past isn't always a good predictor of the future.
• Forward P/E: This uses analysts' estimates for the next year's earnings. It's forward-looking, which is great for valuing growth. The risk? Analysts can be wrong—sometimes spectacularly so.
• The Quality of Earnings: Not all earnings are created equal. Companies can use accounting tricks within Generally Accepted Accounting Principles (GAAP) to make their earnings look better than they really are. A true value investor, in the spirit of Benjamin Graham, digs into the financial statements to understand the quality of the earnings, not just the number.

Imagine two pizza shops for sale, each for €100,000.

• Pizza Palace earns €10,000 per year. Its P/E ratio is 10 (€100,000 / €10,000).
• Slice City earns €5,000 per year. Its P/E ratio is 20 (€100,000 / €5,000).

On the surface, Pizza Palace looks like the better deal. You pay less for its earnings. But what if Slice City just patented a revolutionary new pizza oven that will triple its profits next year? And what if Pizza Palace's lease is about to expire, and its rent is set to double? The P/E ratio gives you the starting price tag, but it doesn't tell you the whole story. You still have to do your homework and “look inside the pizza shop.”

The P/E ratio is a fantastic shortcut, but it has blind spots. Be aware of them:

• No Earnings, No P/E: If a company is losing money, it has negative earnings, and the P/E ratio is meaningless. This is common for young, high-growth startups or companies in deep trouble.
• Cyclical Blindness: For Cyclical Stocks (like car manufacturers or airlines), the P/E can be a trap. Their P/E often looks lowest right at the peak of their business cycle, just before earnings collapse. Conversely, it can look highest at the bottom of a recession, just before things turn around.
• It Ignores Debt: A company might have a low P/E but be drowning in debt. The P/E ratio only looks at equity value, not the total company value. For this reason, many professionals prefer metrics like EV/EBITDA, which accounts for debt.

The P/E ratio is an essential tool, not a magic formula. For a value investor, a low P/E is not an automatic 'buy' signal, but an invitation to start asking questions. Why is it cheap? Is the market missing something, or is there a genuine problem with the business? A high P/E isn't an automatic 'avoid' either, but a warning to be skeptical of lofty growth expectations. Using the P/E ratio wisely means using it as a starting point for deeper investigation, always with a healthy dose of Margin of Safety in mind. It helps you find interesting rocks to turn over, but the real treasure is found by understanding the business underneath.