What Is a P/E Ratio?
The Price-to-Earnings (P/E) ratio is the most widely used metric for valuing a stock. It tells you how much you're paying for each pound (or dollar) of a company's annual earnings.
Formula: P/E ratio = Share price ÷ Earnings per share (EPS)
Example: A share trading at £50 with EPS of £5 has a P/E ratio of 10. You're paying £10 for every £1 of annual earnings. If EPS is £2, P/E is 25 — you're paying more per pound of earnings, implying the market expects faster growth.
No metric tells the full story of a stock alone. P/E, EPS, dividend yield, and market cap are all tools to understand valuation and company fundamentals — not crystal balls. Always compare metrics to industry peers and historical averages, not in isolation.
Earnings Per Share (EPS)
Earnings Per Share (EPS) is the company's net profit divided by the number of shares outstanding. It tells you how profitable the company is on a per-share basis.
Formula: EPS = Net profit ÷ Number of shares outstanding
A company earning £100 million with 50 million shares has EPS of £2. If you then multiply EPS by the P/E ratio, you get back to the share price.
EPS growth over time is one of the most important signals for long-term investors — companies that consistently grow earnings tend to see their share prices rise over time.
Market Capitalisation
Market cap = share price × total shares outstanding. It's the total market value of the company. Market caps are divided into tiers:
- Large cap: £/$ 10 billion+. Established, stable companies (Apple, HSBC, AstraZeneca). Lower risk, lower growth potential.
- Mid cap: £/$ 2–10 billion. Growing companies, more volatile but higher growth potential.
- Small cap: Under £/$ 2 billion. Higher risk, higher potential returns, less analyst coverage.
Dividend Yield and Payout Ratio
Dividend yield = annual dividend per share ÷ share price. A 4% yield means for every £100 of shares you own, you receive £4/year in dividends.
Payout ratio = dividends per share ÷ EPS. A 50% payout ratio means the company pays out half its earnings as dividends and retains the other half. High payout ratios (80%+) suggest less room to grow the dividend if earnings dip.
Price-to-Book Ratio (P/B)
P/B compares the share price to the company's book value (net assets — what would be left if you sold everything and paid all debts). A P/B below 1 suggests the market values the company at less than its assets — potentially undervalued. A P/B of 3 means you're paying £3 for every £1 of net assets.
P/B is most useful for banks, insurers, and asset-heavy businesses. It's less useful for tech companies whose main assets are intangible (software, brand, intellectual property).
Putting It Together: Reading a Stock in 5 Steps
- Revenue and earnings trend: Is revenue growing year-over-year? Is EPS growing? Declining earnings are a warning sign.
- Valuation (P/E): How does the P/E compare to industry peers? A software company at P/E 40 may be normal; a utility company at P/E 40 would be very expensive.
- Balance sheet health: How much debt does the company carry? High debt (debt-to-equity above 2x for most industries) increases risk, especially in rising rate environments.
- Cash flow: Does the company generate positive free cash flow? Cash flow is harder to manipulate than earnings and is the ultimate measure of financial health.
- Competitive moat: Does the company have sustainable competitive advantages — brand, network effects, switching costs, patents — that protect future earnings?
The evidence consistently shows that individual investors (and most professional fund managers) underperform simple index funds over 10+ year periods. Understanding how to read a stock is valuable knowledge, but for most people, holding a low-cost global index ETF is more likely to build long-term wealth than trying to pick individual winners. Stock analysis is a skill worth developing — but start with a core index fund, not instead of one.