What does a price/earnings ratio tell me?Medium

How many years of current earnings you are paying for. It is a compression of an entire forecast into one number, and it compares almost nothing on its own.

3 min read · 581 words

The short answer: the price/earnings ratio is the share price divided by earnings per share. Read literally it says how many years of current earnings you are paying for. Read properly it is a whole forecast — growth, risk and how long both last — compressed into a single number, which is why it compares almost nothing on its own.

What the number contains

Two companies earning the same amount today can be worth very different amounts, and a P/E is where that difference goes. A higher one is the market saying some combination of: earnings will grow, the earnings are dependable, and the growth will last. A lower one says the reverse. Neither is a judgement about whether the price is right — it is a description of what the price implies.

This is why "expensive" and "cheap" are the wrong words for a P/E, and why they are not used on this site. The number is not a price tag, it is an implied forecast, and the useful question is always whether that forecast is plausible rather than whether the ratio is high.

Four things that must match before two are comparable

Which earnings. Last year's, this year's estimate, next year's estimate, or a company's own adjusted figure — four different denominators travelling under one name, and the last is defined by the company itself.
The accounting. Different treatments of the same underlying business produce different earnings. Reading financial statements is where those differences live.
The capital structure. Earnings are after interest, so a heavily indebted company's earnings are a smaller, riskier number. Two P/Es can differ purely because of debt, which is why enterprise value measures exist.
Where the company is in its cycle. This is the one that catches people out, below.

The trap in a cyclical business

For a company whose earnings swing with an economic cycle, the P/E goes the wrong way. At the top of the cycle earnings are at their highest, so the ratio looks low — exactly when it may be least durable. At the bottom earnings collapse and the ratio looks enormous, or goes negative and stops existing. The number is at its most reassuring precisely when the denominator is at its least representative.

What is left out entirely

Cash flow. Earnings are an accounting measure and cash is a fact. A company can report earnings without generating cash for years.
The balance sheet. Debt, pension obligations, leases. None of it is in the ratio.
Loss-making companies. A negative denominator makes the ratio meaningless, so it is simply not quoted — which quietly removes an entire class of company from any comparison built on it.

What it is genuinely useful for

Two things, both modest and both real. It is a fast way to see what the market is implying, so you can ask whether you believe it. And it is a way to compare one company against its own history, where the accounting and the business are at least the same — which removes three of the four mismatches above at a stroke.

For the fuller versions, valuation works through discounted cash flow and multiples together, and the implied growth calculator runs the ratio backwards: given this P/E, what growth rate is being assumed?

The one sentence to take away

A P/E is a forecast in disguise, so the question it deserves is never "is this high or low" but "what does this number assume, and do I believe it".