Earnings and the P/E ratio

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Key idea: P/E tells you how many dollars you pay for each dollar of yearly profit. A lower number is cheaper only if the profits are just as solid.

Earnings per share (EPS) is a company's profit for the year divided by its number of shares. The price-to-earnings ratio (P/E) is the share price divided by EPS.

If a share costs $60 and the company earned $3 per share, the P/E is 20. You are paying $20 for every $1 of this year's profit. Flip it over and you get the earnings yield: $3 / $60 = 5%.

P/E is popular because it is quick. It lets you compare a $60 share with a $600 share on equal terms. A P/E of 12 is not automatically a bargain and a P/E of 35 is not automatically expensive: the higher number may be fair for a company whose profits grow quickly and reliably.

Tomorrow we look at the cases where P/E misleads, which is more often than most people think.

Quick check

A share costs $45 and earnings per share are $3. What is the P/E?

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