10.2 Analysis of Published Accounts – Investment Ratios
Price/Earnings (P/E) Ratio: Calculation and Interpretation
What is the P/E ratio? 📈
The P/E ratio tells you how much investors are willing to pay for each pound of a company’s earnings.
Formula:
\$P/E = \dfrac{\text{Market Price per Share}}{\text{Earnings per Share (EPS)}}\$
Think of it like buying a ticket to a concert. The ticket price is the market price, and the “value” you get from the concert is the earnings. If the ticket is cheap compared to the experience, the P/E is low – a good deal! If it’s expensive, the P/E is high – maybe too pricey.
- Find the market price per share (P). This is the current share price on the stock exchange.
- Find the earnings per share (EPS). EPS = Net Income ÷ Number of Shares Outstanding.
- Divide P by EPS. The result is the P/E ratio.
- Check the period. Use the most recent EPS (trailing 12 months) unless the question specifies otherwise.
Example Calculation
| Item | Value (£) |
|---|
| Market price per share (P) | £25.00 |
| Net Income | £5,000,000 |
| Shares Outstanding | 200,000 |
| EPS | \$\dfrac{5,000,000}{200,000} = £25.00\$ |
| P/E Ratio | \$\dfrac{25.00}{25.00} = 1.0\$ |
In this case, the P/E ratio is 1.0, meaning investors pay £1 for every £1 of earnings.
Interpreting the P/E Ratio
- Low P/E (e.g., < 10) – The stock may be undervalued or the company faces challenges.
- High P/E (e.g., > 20) – The stock may be overvalued or investors expect high growth.
- Compare with peers. A company with a P/E of 15 in a sector where the average is 25 might be a bargain.
- Trend over time. Rising P/E can signal growing confidence; falling P/E may warn of trouble.
Remember: P/E is just one lens. Combine it with other ratios (e.g., ROE, debt‑to‑equity) for a fuller picture.
Exam Tips 🧠
- Always state the formula clearly before plugging in numbers.
- Show all steps – examiners look for the process, not just the answer.
- Check units: EPS should be in the same currency as the share price.
- When comparing P/E ratios, note the industry average or market benchmark.
- Use the word interpret in your answer – explain what the ratio tells you about the company.
- Be mindful of trailing vs. forward P/E if the question specifies.
Good luck, and remember: a clear, step‑by‑step answer is often rewarded more than a single number!