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Understanding price-to-earnings ratio

The price-to-earnings (PE) ratio is a simple tool to evaluate whether you’re paying a fair price for a company’s shares.

The PE ratio can help you compare investment options before you buy and see if a company is trading at a fair value. 

In this article, we’ll cover: 

What does PE ratio indicate? 

How is the PE ratio used? 

How to calculate a PE ratio

Trailing vs forward PE ratios

What is a good price-to-earnings ratio? 

What does a negative PE ratio mean? 

Pros and cons of the PE ratio

What does PE ratio indicate?

A price-earnings ratio (also called PE ratio or PER) looks at a company’s share price relative to its earnings per share. This means you can see how much investors are willing to pay for its shares. 

The PE ratio reflects market expectations. A high price-to-earnings means investors expect growth from the company, while a low PE ratio may mean the company is undervalued or is facing challenges. 

Explore: How to invest in stocks and shares

How is the PE ratio used?

Analysts use the PE ratio to work out the current perception of a company in 2 ways:

  • Compare competitors: Look at the PE ratio of similar companies in the same industry
  • Track performance: Compare the company’s current and past price-to-earnings and see if it’s priced higher or lower than usual

How to calculate a PE ratio

To work out a company’s PE ratio, you need to look at:

  • Current share price - what investors are paying on the stock market
  • Earnings per share (EPS) - a company’s profit divided by its number of listed shares

The PE ratio formula is:

PE ratio = market value per share ÷ earnings per share

For example, if a company’s stock is priced at AED 50 per share and its earnings per share (EPS) is AED 2, the PE ratio can be calculated in the following way: 50 ÷ 2 = 25. This means investors are paying AED 25 for every AED 1 the company earns. 

Alternatively, most online trading brokers (like HSBC WorldTrader) list PE ratios along with other data about a company, so just look for out for that.

Trailing vs forward PE ratios

There are 2 main types of PE ratios:

  • Trailing PE: This is based on actual earnings from the last 12 months
  • Forward PE: Based on the estimated earnings in the next 12 months

What is a good price-to-earnings ratio?

There isn’t a benchmark for a 'good' PE ratio. This depends on factors like the industry, the company’s current growth, and market conditions. 

PE ratios tend to rise in bull markets, reflecting investor optimism, while they often fall in bear markets, as investors become more cautious.

To judge if a PE ratio is high or low, compare it to the industry average and the company’s historical PE ratios.

Technology and healthcare companies often have high PE ratios as they’re seen as having strong growth potential. Meanwhile, industries like manufacturing and utilities often have lower PE ratios because they may have slower but steady growth.

What does a negative PE ratio mean?

If a company has a negative price-to-earnings ratio, it means it’s not making a profit. This could be because of:

  • Financial trouble: If a company is struggling, it’s less attractive to investors
  • Expansion: A company may be investing in future growth which affects current earnings - but sets itself up for future profits

A negative or low PE ratio doesn’t always mean a company is a bad investment. Look at other factors and the broader market context. If it is deemed to have strong growth prospects and is considered undervalued, it could be a good opportunity.

Find out more: Myths about investing

Pros and cons of the PE ratio

Pros

  • Simple and easy to understand and use
  • Standardised way to compare companies
  • Insight into market sentiment

Cons

  • PE ratios don’t account for a company’s debt
  • Accounting methods can hide true earnings or losses
  • Short-term focus on current earnings

Key takeaways

The price-earnings ratio helps you make an informed decision about an investment. It compares a company’s stock price to its earnings, and to other companies. The PE ratio shows market expectations and valuation. 

Bear in mind that the PE ratio is just one factor to help you look at a company’s value. Always consider the context, like industry averages and other metrics. And remember that past performance is no guarantee of future returns, and you may get back less than what you invest.

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Disclaimer

In the United Arab Emirates, this article is published by HSBC Bank Middle East Limited (“HBME”) - UAE Branch, P.O. Box 66, Dubai, UAE, which is regulated by the Central Bank of the UAE and lead regulated by the Dubai Financial Services Authority. In respect of certain financial services and activities offered by HBME, it is regulated by the Securities and Commodities Authority in the UAE under licence number 602004.

This article is for information purposes only and does not constitute investment advice or a recommendation to purchase any specific investment product. Any views or opinions expressed are subject to change without notice. Before making an investment decision, you should seek advice from your HSBC relationship manager or another professional adviser taking into account your individual financial circumstances and objectives. HBME is not responsible for any loss, damage or other consequences of any kind that you may incur or suffer as a result of, arising from or relating to your use of or reliance on this article.