The P/E ratio is a very simple way of measuring how expensive a share is.
If we think of the E as being profit, (how much profit does this company make), and the P as the market value (the price of the company), we can compare the market value of that company. Dividing the market value (P) by the profit (E) creates the P/E ratio.
For example, a company that makes a profit of $1 million, and it is on the market at the moment for $15 million. We would then say that this company has a P/E ratio of 15 divided by one, which is equal to 15.
Now, is this expensive, or is it cheap?
Well, if you have a look at the market as a whole, the market in Australia, is worth approximately a P/E of 11 to 12 (depending on the index used - for example the S&P/ASX 200 (ASX: XJO) (Index: ^AXJO) and whose estimates), so therefore a P/E of 15 is a little bit more expensive than the market.
By way of example, BHP Billiton (ASX: BHP) is selling on a trailing P/E of 8.6, Cochlear (ASX: COH) has a trailing P/E of 21.2 and Insurance Australia Group (ASX: IAG) sells at 22.9 times earnings.
But, whenever we look at P/E ratios, we shouldn’t look at it in isolation — we should really be looking at the profit that the company makes today, and whether or not it is going to make more profits tomorrow.
If we just simply say that the company is making $1 million profit this year, a million dollars next year, a million dollars the year after — in other words, there is no change in the company’s profitability, then it would take us 15 years, if we were to buy the shares, to get our money back.
Now, some might say, that is quite expensive. If we then take a look at this same company, and it makes $1 million profit this year, $2 million the year after, $4 million the year after that, $8 million the year after that, then we could calculate that we would get our money back in four years, because if you add them, up, 1 + 2 + 4 + 8 = 15.
So all of a sudden, this company is not really that expensive. The profits are growing quite quickly, and the P/E ratio is a very shorthand way of looking at how expensive a company is. To understand the P/E ratio, we then have to look at the profitability of the company, and how much profit it is making in future years.
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A version of this article, a podcast by David Kuo, originally appeared on fool.co.uk