A lot of investment commentators refer to a price-to-earnings ratio when writing about shares. But what is this P/E ratio? Why does it matter?

Valuation metric

To understand the role of a P/E ratio, it’s helpful to start by thinking about share prices. A company’s share price helps explain its market capitalisation. If a company has a share price of £1 and 1m shares in circulation, its market cap is £1m. If the share price doubles to £2 and the number of shares remains the same, the market capitalisation would be £2m.

What does that mean? In theory, it means that if someone came along with £2m to spend, they would be able to buy all of the company’s shares and thus the company. In practice things may be more complicated, as for example a bidder may need to offer a premium to persuade existing shareholders to part with their shares. Nonetheless, a market cap is a good albeit rough guide to a company’s valuation. But how do investors decide such a valuation?

P/E ratio and valuation

One way to do this is by looking at a company’s earnings. Let’s say that to buy the company with a £2m valuation, I want to borrow the £2m. I could hopefully use the earnings from the company to pay back my loan. If the company earnings are £200,000 per year, it would take me 10 years to pay off the £2m. If the price (£2m) is divided by the earnings (£200,000) the arithmetic result is 10. So, we say that the company has a P/E ratio of 10.

In reality, things wouldn’t work quite like that. The longer I took to repay my debt, the more I would usually have to pay in interest. Plus, many companies’ earnings aren’t smooth. So just because a company earns £200,000 this year, it doesn’t mean the same will happen next year.

But a P/E ratio could still give me some important information. A low P/E ratio can suggest the company may be trading cheaply. A high P/E ratio may mean it is overvalued. Even as a private investor looking at the share price, not a takeover firm thinking of buying the whole company, that valuation metric could be useful to me.

Looking at the bigger picture

So, does that mean that Imperial Brands with its P/E ratio of less than seven is a bargain, or that Spirax-Sarco with a P/E ratio over 60 is overpriced?

Not necessarily. That is because earnings could change in future. Imperial’s tobacco focus risks earnings falling as people quit smoking. Spirax-Sarco has demonstrated it can grow earnings, for example by making acquisitions. Using my example above of buying a company with debt then repaying the loan from future earnings, that could help explain Imperial’s low P/E ratio and Spirax-Sarco’s high P/E ratio.

It’s important to remember that a P/E ratio is only one of a number of valuation metrics many investors use. Used properly, though, I do find a P/E ratio is a useful and simple analytical tool to help me make investment decisions. It can help me identify possibly undervalued companies that merit further investigation as potential additions to my portfolio.

The post Can using a price-to-earnings (P/E) ratio help me invest better? appeared first on The Motley Fool UK.

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Christopher Ruane owns shares in Imperial Brands. The Motley Fool UK has recommended Imperial Brands. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.