The tool investors can use to determine a company's potential for growth

Stock market guide: the p/e ratio

Rating a share's prospects is not easy. But one common yardstick reveals the market's view. John Andrew continues his series on the share page with an explanation of the price-earnings ratio.

The penultimate column on The Independent's shares page is headed "P/E", the abbreviation for "price-earnings ratio" one of the traditional tools used to assess whether a share is worthwhile. "It is widely quoted, but little understood," says Gill Nott, the chief executive of ProShare, the organisation which promotes share ownership.

The p/e ratio is a simple concept. It is calculated by dividing the company's current share price by earnings per share over the last 12 months. Earnings per share must not be confused with dividends. The latter is the income distributed to shareholders. On the other hand, earnings per share generally refers to the net profit after the deduction of the dividend payable on preference shares. These are shares which pay a fixed dividend to shareholders each year.

The ratio indicates how many years it would take for the net profit attributable to each share to equal the current share price. As a rule, the higher the p/e, the more "expensive" the share. It may be also be viewed as the City's confidence ratio. Generally, the higher the p/e, the higher the market's regard for the company.

A high p/e could indicate the company's performance is bounding ahead of its most recently published earnings. In other words, investors are expecting increased profits to be announced and consequently the shares are in demand. Investors are prepared to pay a higher price now that reflects better things in the future. Of course, only time will reveal whether this is a correct judgement.

On the other hand, a company which is doing badly may have a high p/e. This reflects the view that it may be the subject of a takeover bid. Even the whiff of a possible bid can increase a company's share price.

Glancing down the p/e column in our share price page, you will notice that there are one or two gaps. This is because in these cases, such factors as taxation, income distribution or objectives, makes the ratio meaningless or irrelevant.

The p/e ratio for a particular company can differ from one publication to another. For example, the ratios in The Independent may differ from those in a stockbroker's newsletter. The reason for such differences is that although the concept of the ratio is simple, one of the factors in its calculation is complex.

The current share price is a matter of fact. The differences arise because of the figure used for "earnings per share". There are three basic ways of defining earnings: the nil; the net and the maximum methods. An explanation of the three methods, which centre on how the payment of dividends affects a company's mainstream tax, is complex and it is sufficient for our purposes to say that each one produces a different result.

There is another reason as to why differences in the p/e calculations can differ. The development of UK fiscal law over recent years has resulted in tax provisions being more subjective than in the past. If adjustments are made, for whatever reason, to the figures supplied by the company, variations in p/e ratios will arise.

It is also worth noting that often a prospective p/e ratio is given in stockbrokers' newsletters or press comment. This simply means an estimate of the company's future earnings per share has been used in the calculations as opposed to the last published or historic earnings.

Sometimes you will see a reference to a particular p/e ratio being "undemanding". This means that the ratio is low compared with similar companies. In other words, the company's growth potential is not considered to be high. As it is easier for a company to miss high growth expectations than ones which are low, the p/e is said to be undemanding.

Remember that if a company has a high p/e ratio, it is no guarantee that the future will live up to expectations. The market's confidence may be completely misplaced. Furthermore, two companies may have identical p/es based on present earnings, but one may have far better prospects than the other.

The p/e is only one of the yardsticks that professional use when assessing shares. Investors certainly should not use it in isolation when making their decisions. We will take a look at more investment yardsticks next week.