What is a price-to-earnings ratio?

Here is a puzzle that trips up almost every new investor. One share costs £5. Another costs £500. Which one is cheaper?

The honest answer is: you have no idea yet. A £5 share can be wildly overpriced and a £500 share can be a bargain. The raw price tells you almost nothing on its own, because it depends entirely on how the company chose to slice itself up. To compare two businesses fairly, you need to line the price up against something real that the company produces — its profit. That is exactly what the price-to-earnings ratio does, and it is one of the most useful numbers a Student Investor can learn to read.

The one-line definition

The price-to-earnings ratio — almost always written as P/E — compares a company’s share price with how much profit it makes for each share. The formula is refreshingly simple:

P/E ratio = share price ÷ earnings per share

“Earnings per share” (often shortened to EPS) is just the company’s total yearly profit divided by the number of shares that exist. So if a firm makes £100m of profit and has 100m shares, its earnings per share is £1. If its share price is £20, then its P/E is 20 ÷ 1 = 20.

That single number has a lovely plain-English meaning: investors are paying £20 for every £1 of yearly profit the company earns. Put another way, if profits never changed and the company handed you every penny, it would take 20 years of earnings to get your money back. The P/E turns an abstract price into a “how many years of profit am I paying for?” question — and that is something a human brain can actually reason about.

Why the raw share price is a trap

The reason the P/E matters is that the headline price is almost meaningless by itself. As we explain in how to read a share price, the big number on a ticker is simply the price of the last trade — and a company can set that number almost anywhere by choosing how many shares to issue.

Split a business into a billion shares and each one is cheap; split the same business into a million shares and each one looks pricey. Neither choice changes what the company is actually worth. That total worth is its market capitalisation — the share price multiplied by the number of shares. The P/E ratio is clever because it quietly cancels out the share-count trick: it always tells you the price relative to profit, no matter how the company sliced itself up. That is why professionals reach for the P/E, not the raw price, when they ask “is this share expensive?”

Reading a high or low P/E

Once you can calculate a P/E, the next skill is interpreting it — and this is where beginners often jump to the wrong conclusion.

A high P/E

A high P/E — say 40 or more — means investors are paying a lot for each pound of current profit. That is not automatically silly. Usually it means the market expects profits to grow quickly in the future, so today’s price is being justified by tomorrow’s bigger earnings. Fast-growing technology firms often carry sky-high P/Es for exactly this reason. The risk is that all that optimism is already baked in: if growth disappoints, a high-P/E share can fall hard.

A low P/E

A low P/E — say under 10 — means the share looks cheap relative to its profits. Sometimes that is a genuine bargain the market has overlooked. But often it is a warning: investors may expect those profits to shrink, or the business to face trouble, so they are unwilling to pay much for them. A low P/E can be a value opportunity or a value trap, and telling the two apart is a big part of the investing craft.

The key lesson is that a P/E number is a question, not a verdict. “This share has a P/E of 8” should make you ask why so low?, not shout “bargain!”.

The golden rule: compare like with like

A P/E ratio in isolation is nearly useless. It only comes alive when you compare it against something — and the fairest comparison is between companies in the same industry.

Different industries live at completely different P/E levels, and that is perfectly normal. A steady supermarket chain with slow, predictable growth might trade on a P/E of 12. A cloud-software company growing 30% a year might trade on a P/E of 50. Comparing those two numbers directly is meaningless — it is like comparing a marathon time with a sprint time. But comparing two supermarkets, or two software firms, against each other can be genuinely revealing.

Company	Share price	Earnings per share	P/E ratio
Supermarket A	£3.00	£0.25	12
Supermarket B	£4.50	£0.25	18

Both supermarkets earn the same 25p per share, but B costs more for that identical profit. So B has the higher P/E — investors are paying more for each pound of its earnings. That does not automatically make B a worse buy; maybe B is opening new stores and growing faster. But now you have a sharp, specific question to investigate, instead of a vague feeling. That is the P/E doing its job.

What the P/E ratio quietly ignores

For all its usefulness, the P/E has real blind spots, and a good investor keeps them in mind.

• It says nothing about debt. Two companies can have the same P/E while one is drowning in borrowing and the other has none. Profit is only half the story.
• Profits can be lumpy or one-off. A single good year — say, a company that sold a building — can flatter earnings and make the P/E look artificially low.
• Loss-making firms have no P/E at all. If a company makes no profit, there is nothing to divide the price by, so the ratio is blank or negative. Many young, exciting businesses fall into this camp for years.
• It is backward-looking. The standard P/E uses last year’s profits, but you are buying a share for its future. That is why analysts also use a “forward P/E” based on expected earnings — a forecast, and therefore only ever an educated guess.

None of this makes the P/E useless. It just means the ratio is one instrument on the dashboard, not the whole cockpit. It pairs naturally with the ideas in why shares move on earnings news: because the P/E is built on profit, an earnings surprise can reshape it overnight.

How to use the P/E as a Student Investor

You will not be graded on picking winning tips — the Challenge rewards understanding, not luck. But the P/E ratio is a brilliant training tool for your virtual £100,000 portfolio. When you are weighing up a company, try this simple routine:

1. Find the P/E. Most market apps and websites list it right next to the share price. You rarely have to calculate it by hand.
2. Ask “compared to what?” Look up a couple of rivals in the same industry. Is your company’s P/E higher or lower than theirs?
3. Ask “why?” If it is much higher, what growth story justifies it? If it is much lower, what worry is the market pricing in?
4. Zoom back out. Remember the P/E is one clue among many — sitting alongside dividends, debt, and the company’s prospects. Never buy on a single number.

If you want to see real P/E ratios in the wild, the London Stock Exchange lists them for UK-listed companies, and the UK regulator’s InvestSmart pages are a solid plain-English guide to the basics of shares. Cross-checking a company’s P/E against its industry peers is a habit that will serve you long after the Challenge is over.

The takeaway

The price-to-earnings ratio takes a share price — a number that means almost nothing on its own — and anchors it to something real: how much profit the company actually earns. A P/E of 20 means you are paying £20 for every £1 of yearly earnings. High P/Es usually signal high expectations; low P/Es signal caution or a possible bargain; and no single P/E is “good” or “bad” until you compare it with similar companies and ask why it sits where it does. Learn to read it, treat it as a question rather than an answer, and one of the market’s most quoted numbers turns from jargon into genuine insight.

This article is educational and is not financial advice. The companies and figures used are simplified illustrations to explain how the price-to-earnings ratio works, not descriptions of real firms or recommendations to buy or sell anything.