Price to Earnings Ratio

The Price to Earnings Ratio compares the share price with earnings per share. It shows at what multiple of annual earnings a share is valued. A high ratio can indicate high expectations for future growth. Its inverse is the earnings yield, which can be compared with other investment alternatives, which is what makes the metric so widespread in capital markets. Its methodological place matters: because both numerator and denominator are defined after interest and tax, the ratio belongs to equity value and must not be confused or mixed with enterprise value multiples such as EV/EBITDA.

The main weakness follows from this: the ratio responds directly to capital structure, since high interest expense reduces earnings, and to the tax rate, so companies with different financing or domicile are only partly comparable. Added to this is the sensitivity of annual earnings to one-off effects and accounting judgements, and its uselessness in a loss year, since a negative ratio carries no meaning. In transaction practice the price/earnings ratio therefore plays a secondary role and is used mainly for listed comparables and in analysing the earnings impact of an acquisition, where it explains the link between valuation and earnings per share dilution.

The ratio is calculated as the share price divided by earnings per share, or equivalently as market capitalisation divided by net income. A reading of 15 means investors pay 15 euros for one euro of annual profit, which corresponds to an earnings yield of around 6.7 percent. A trailing view based on the last twelve months should be distinguished from a forward view based on estimates for the coming twelve months, which is lower when expected earnings rise and the share price is unchanged. Where a company is loss-making, the ratio is not economically meaningful. Revenue-based multiples are one possible alternative for valuation.