P/E ratio: how to tell if a stock is cheap or expensive

Every time someone says a stock is "expensive" or "cheap", they're usually talking about one number: the price-to-earnings ratio, or P/E.

The maths

P/E is the share price divided by the company's profit per share over the last year, called earnings per share or EPS.

Another way to see it: if profits never grew, it would take 20 years of profits to earn back what you paid. That's why a higher P/E means you're paying more for each rupee the business earns.

Why would anyone pay 80 times profit?

Because the market is pricing the future, not the past. If a company's profit is expected to double every few years, today's P/E overstates how expensive it really is. A business earning ₹10 a share today that will earn ₹40 in five years looks very different from one stuck at ₹10.

So a high P/E is a bet on growth, and a low P/E is often a sign that the market expects trouble: falling profits, debt, competition, or a cyclical business at the top of its cycle.

Flip it: the earnings yield

Turn the ratio upside down and you get the earnings yield: profit as a percentage of the price. A P/E of 20 is an earnings yield of 5%.

This is useful because you can compare it with what safe investments pay. When government bonds or fixed deposits pay 7%, a stock with an earnings yield of 2.5% needs a lot of growth to be worth the risk. This is one reason stock prices tend to fall when interest rates rise. See our explainer on bonds and yields.

Three ways P/E can fool you

• One-off profitsA company that sold a factory last year will show a big profit and a low P/E that won't repeat. Check whether earnings came from the core business.
• Comparing across sectorsBanks, IT companies and consumer brands normally trade at very different P/Es. Compare a company with its own history and its direct rivals, not the whole market.
• LossesIf a company makes a loss, P/E has no meaning. Young tech companies and turnarounds often need other measures, like price-to-sales.

Trailing vs forward

The P/E you see on most apps is trailing: based on the last 12 months of actual profit. Analysts also quote a forward P/E based on next year's expected profit. Forward P/Es look lower for growing companies, but they rest on forecasts that can be wrong.

The same idea applies to whole markets. NSE publishes the P/E of the Nifty 50 every day, and investors watch it to judge whether the market as a whole looks stretched or cheap compared with its own history.