The P/E ratio is the share price divided by earnings per share. A stock at $100 earning $5 a share trades at a P/E of 20 — you're paying $20 for each $1 of annual profit.
People reach for it first because it's simple and everywhere. But the common reading — "low P/E = cheap, high P/E = expensive" — is where most of the mistakes start.
What it's really measuring
A P/E is the market's verdict on a company's future, not its present. A high multiple usually means investors expect earnings to grow fast; a low one often means they expect stagnation or trouble. So a 35x stock isn't automatically expensive, and a 7x stock isn't automatically a bargain — sometimes 7x is the market correctly pricing a business in decline. The number is a question ("what growth is priced in?"), not an answer.
Trailing vs forward
- Trailing P/E uses the last 12 months of actual earnings — real, but backward-looking.
- Forward P/E uses analysts' estimate of next year's earnings — relevant, but only as good as the forecast.
A big gap between the two tells you the market expects earnings to change sharply.
Where it breaks
- No earnings, no ratio. A company losing money has a meaningless or negative P/E. Early-growth and cyclical-trough companies fall here.
- Earnings are gameable. Accounting profit can be flattered by one-offs; that's why cash-flow-based measures are a useful cross-check.
- It ignores debt. Two companies with the same P/E can carry very different leverage. EV/EBITDA addresses that.
How to use it
Compare a company to its own history and to close peers, not to the whole market. Ask what growth the multiple implies and whether that's plausible. And never let it travel alone — pair it with EV/EBITDA, free-cash-flow yield, and a look at the balance sheet.
Bottom line
P/E tells you how much the market will pay for a dollar of earnings, which is really a statement about expected growth and risk. It's a fast first read, not a verdict — and it's only honest alongside other measures.