Ask Fidelity: What is the price-to-earnings ratio and how do you calculate it?

Many investors will have heard of the price-to-earnings or p/e ratio and use it as a quick yardstick for whether a stock ( or an entire stock market) is looking overvalued or undervalued. Here we explain how it’s calculated and how to use it.

What is the price-to-earnings ratio?

The p/e ratio is the most popular yardstick for assessing whether an individual stock is cheap or expensive. It can also be used to value an entire stock market or industry sector. It is simple and intuitive, so it can be calculated and understood by private investors, although professionals use it too.

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How do you calculate the price-to-earnings ratio?

There are two ways to calculate the p/e ratio. There are two different ways to look at the same thing so there is no difference in the result.

The first is perhaps more intuitive. Here, we divide the company’s market value (also called market capitalisation) by its annual profits or earnings. It’s important to note that, although newspapers often focus on profits before tax, to calculate the p/e ratio we use after-tax earnings.

Where can you find these figures? The market value changes from moment to moment while the stock market is open but you can find an almost real-time figure on websites such as fidelity.co.uk. The after-tax earnings figure for the most recent full year can be found in the annual report and accounts of the company concerned or on our website or elsewhere on the internet. Look for the financial statements and then the ‘profit and loss account’ or ‘income statement’. You need the total figure, which is likely to be in the millions or billions of pounds (or dollars or euros), and not the per-share figure in pence.

For example, Shell has a market value at the time of writing of £149bn and its latest report and accounts for the year to 31 December 2023 show an after-tax income of $19.4bn (although Shell described it as ‘income attributable to Shell plc shareholders’; you may encounter different wording at different companies). At the current exchange rate, $19.4bn is equivalent to £14.8bn. If we divide £149bn by £14.8bn we get a price-to-earnings ratio of 10.

The other way to calculate the p/e ratio is to use per-share figures for both the ‘p’ and the ‘e’, in other words the share price and the ‘earnings per share’ figure. We can get the share price from a number of online sources, including the Fidelity website, while the earnings per share (or ‘eps’) can be found in the company’s annual report, also under the income statement, or elsewhere online.

Now in investment, unfortunately, few things are free from complications and p/e ratios are no exception. The first complication is that a company’s income statement will sometimes include more than one figure for earnings per share. Shell’s for last year, for example, has ‘basic earnings per share’ of $2.88 and ‘diluted earnings per share’ of $2.85. The difference arises because basic earnings per share are calculated by dividing the company’s total earnings in the year (that $19.4bn figure in the case of Shell) by the number of shares in the company, while the ‘diluted’ earnings per share figure takes into account hypothetical increases in the number of shares in existence. A full explanation is beyond the scope of this article, but the good news is that the two figures tend not to differ by much.

The second complication is that it’s very common to use a different measure of earnings for the calculation of the p/e ratio. When we worked out Shell’s p/e ratio above we used the ‘official’ figure for earnings from the annual report, which is also called the ‘statutory’ figure because the annual report is required by company law to include it. But sometimes another measure, ‘adjusted earnings’, is used. Adjusted earnings tend to differ from the statutory figure thanks to the exclusion of certain non-recurring items. The idea is to make earnings figures more comparable from one year to the next, although some more sceptical analysts say they allow companies to downplay certain expenditure and make the business appear more profitable. Without getting bogged down in that debate, we will point out that the statutory figure is verified by the company’s independent auditor, as required by law, whereas the adjusted figure is not.

In any case, you can calculate the adjusted p/e just as we calculated the ‘plain vanilla’ figure above: you divide the company’s market value by its total adjusted earnings, or divide the share price by the adjusted earnings per share. Both should be found in the income statement.

A third complication is that we can also calculate a p/e figure that is based on expected earnings. Here the company’s market value is divided by the average after-tax earnings predicted by City analysts. Ratios based on actual past earnings are sometimes called ‘historic’ and those based on forecasts ‘prospective’.

For all the various different p/e ratios mentioned above, the most important thing is to be sure about which one is being used.

How to use the p/e ratio

The higher a p/e ratio, the less money the company makes on your behalf for each £1 you invest in it. Investors need to ask themselves therefore whether a high-looking p/e is worth paying. It may be; the company could be expected to grow its profits very quickly (which will mean your share of profits also grows and will have the effect of reducing the p/e figure in future).

Equally, while a low p/e may seem to signal a good return on the money you invest, you need to be sure that current earnings will be maintained in future years. ‘Normal’ companies, neither in trouble nor expected to grow especially fast, often find their p/e ratios in the teens; a figure in single digits or in the high teens or more may signal the market’s belief that there are special circumstances at play that would merit investigation.

Broadly similar considerations apply when you use the p/e ratio to value an entire sector or stock market: a low figure may be tempting but could signal investors’ concern about the future; a high value will show their optimism and investors will need to decide whether it is justified.

Important information - the value of investments and the income from them, can go down as well as up, so you may get back less than you invest. Overseas investments will be affected by movements in currency exchange rates. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. Before transferring a pension, compare all the benefits, charges and features and always seek advice if you are unsure.