Price to earnings ratio:
what you pay for each rupee of profit

Price paid for each rupee of yearly profit

When you buy a share you are buying a slice of future profit. The price to earnings ratio, or P/E, tells you how many rupees the market asks for each rupee of profit the company currently earns per share. A P/E of 20 means ₹20 of price for every ₹1 of annual earnings.

It is the most quoted valuation measure for a simple reason: it needs only two numbers that appear on every stock screen. It is also easy to misuse for the same reason.

The formula and its mirror image

The reciprocal is the earnings yield, which expresses profit as a percentage of price. It lets you compare a share directly with the rate on a bank deposit or a bond.

A worked example

A company reported net profit of ₹450 crore and has 10 crore shares outstanding, so earnings per share is ₹45. The share trades at ₹900.

Flipped, the same figures give an earnings yield of 45 ÷ 900 = 5%. Put differently, the business earns 5% of its price each year before any growth.

Now suppose earnings per share grows to ₹54 while the price stays at ₹900.

How to read a multiple of 20

There is no universal good or bad P/E. A high multiple can mean investors expect strong growth, or that a share is simply expensive. A low one can signal a bargain, or a business the market expects to shrink. The number only means something against a comparison.

Sectors differ structurally. Banks, utilities, software and cyclical manufacturers settle at different typical multiples, so crossing sector lines produces misleading conclusions.

Trailing, forward and the distortions to watch for

Trailing P/E uses profit already reported over the previous twelve months. Forward P/E uses analysts' estimates, which are only forecasts. Neither is wrong; they answer different questions.

• One-off gains such as the sale of an asset inflate earnings and flatter the multiple.
• Cyclical firms look cheapest at the top of the cycle when profits peak, and most expensive near the bottom.
• A very small or negative profit makes P/E huge or undefined, so it should be set aside for loss-making firms.
• Different accounting and share counts, including dilution from options, change earnings per share between sources.

Growth, and why a high multiple is not automatically rich

Two companies can trade at the same price while one is growing profit at 5% a year and the other at 25%. Paying 20 times earnings for the second may be reasonable, since each year's profit is larger than the last. The first deserves a lower multiple because what you buy today is roughly what you will have later.

Analysts sometimes divide P/E by the expected growth rate in percent to get a rough PEG figure. A multiple of 20 with growth of 20% gives a PEG of 1, while the same multiple with 5% growth gives 4. The method is crude, because growth forecasts are uncertain, but it explains why a bare P/E can mislead.

Quality of earnings counts as well. Profit that converts to cash and does not need constant capital is worth more than profit that is consumed by new factories and working capital.

A short checklist before relying on the ratio

1. 1Confirm whether the earnings per share used is trailing or forward, and whether it is standalone or consolidated.
2. 2Strip out one-off gains or losses if the reported profit includes them.
3. 3Compare with at least three peers and the company's five-year range.
4. 4Check debt levels, because borrowing can lift earnings while raising risk.
5. 5Treat the answer as a starting point for questions, not a verdict.

The same ratio from the whole-company side

P/E can also be computed for the whole business: market capitalisation divided by total net profit. A company worth ₹9,000 crore with ₹450 crore of profit also has a P/E of 20. The two routes agree as long as the share count and profit are consistent, and the company-level version is handy when per-share data is unavailable.

Enterprise-level multiples, such as enterprise value to operating profit, are used when debt levels differ widely between firms, since P/E on its own ignores how much a company has borrowed to produce its profit.

Three misreadings that cost investors money

The first is treating a low multiple as proof of a bargain. Markets often price a weak business cheaply for good reason, and the cheapness disappears when profits fall. The second is comparing the ratio across countries and sectors without adjusting for interest rates and growth, which differ widely. The third is leaning on a single year of earnings, which may sit at an unusual peak or trough.

A healthier habit is to ask what the ratio would be if earnings fell by a quarter, and whether you would still be comfortable owning the share at that price. If the answer is no, the multiple was relying on conditions that may not last.

Pairing it with other checks

Treat P/E as a screening step, then look at debt, return on equity, cash flow and the growth outlook. A low multiple on a company drowning in debt is no comfort. A returns tool can help you compare how different multiples translate into expected yields, but a ratio on its own is not a recommendation to buy or sell anything.