Investment Jargon: Price to Earnings Ratio (PE ratio)

Price to Earnings Ratio (PE ratio)

Investors profit from shares in two ways: capital appreciation as the share price increases and dividend income. Any profits generated by the company are either paid back to investors or re-invested in the company, and if re-invested wisely this will increase future income. The value of a company therefore depends critically on the amount of profit (earnings) it can generate. The most widely used measure for shares uses the ratio of the share price (P) to the earnings (E) generated by the company​: this is the P/E ratio. A “normal” P/E is around 10 but this varies widely between industries.

For example startup companies have the potential for large earnings in future and often trade at high P/E values, sometimes in the hundreds or thousands. At the other extreme utility companies offer safety through their steady and reliable dividend payments and these companies are not expected to grow earnings like a startup and trade at much lower multiples. Another factor is risk appetite or animal spirits: when the market is in a buoyant mood investors often pay more for the same earnings across all sectors, and during a crisis investors pay a lot less for the same earnings.