How to read a P/E ratio, and when not to trust it

Earnings per share (EPS) is the company's profit after tax divided by the number of its shares. If a company earns ₹1,200 crore a year and has 100 crore shares, its EPS is ₹12. If the share price is ₹300, the P/E is 300 divided by 12, or 25. Investors are paying ₹25 for each ₹1 of yearly profit. The same figure can be found by dividing the company's market value by its yearly profit.

The inverse of the P/E is the earnings yield: 1 divided by 25 is 4 per cent. It lets you compare a share with, say, a bank deposit or a government bond, with the important difference that a company's earnings can grow, and can also fall.

Profit after tax   ₹1,200 crore
Shares             100 crore
EPS                ₹1,200 / 100 = ₹12
Share price        ₹300
P/E                300 / 12 = 25
Earnings yield     12 / 300 = 4%

A trailing P/E uses the earnings of the last four quarters, which have been reported and can be checked. A forward P/E uses analysts' estimates of the coming year, which reflect expectations and can be wrong. Data providers also differ on whether they use standalone or consolidated profit, so the same share can show two P/Es on two websites. When comparing, make sure the figures come from the same source and the same basis.

Investors pay more for earnings they expect to grow quickly, so fast-growing companies usually trade on higher multiples than slow-growing ones. Sectors also differ for structural reasons: a software company, a bank and a cement producer have different growth, capital needs and risk, and their usual P/Es differ accordingly. The exchanges publish the P/E of the broad indices, which gives a rough sense of whether the market as a whole is priced richly or cheaply compared with its own history.

The ratio breaks down in predictable situations.

• Tiny or negative earnings. A company that has just reached profit may show a P/E of several hundred, and a loss-making company has no meaningful P/E at all.
• One-off items. A profit boosted by the sale of an asset, or cut by a one-time charge, distorts the ratio for a year.
• Cyclical businesses. A steel or commodity company often has a low P/E at the top of the cycle, when profits are at a peak, and a high one at the bottom, so the signal is the reverse of what it seems.
• Debt. Two companies with the same P/E can have very different levels of borrowing. Measures such as enterprise value to EBITDA take debt into account.
• Banks and insurers. Their profits depend on provisions and accounting choices, so price to book value is often used alongside P/E.

Treat the P/E as a prompt for further questions. Is it high because growth is strong, or because the price has run ahead of the business? Compare it with the same company over three to five years, and with two or three of its closest rivals. Read the company's own results for revenue growth, margins, debt and cash flow. And remember that no single ratio decides whether a share is a good investment. This guide is general education, not investment advice.

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