When investors, analysts and commentators talk about a company’s valuation, they usually mean how highly its shares are valued relative to a financial measure like earnings. That’s different from its market value, or market capitalisation, which is the share price multiplied by the number of shares in issue. A large company can trade on a low valuation, and a much smaller company can trade on a high one.
This article isn’t personal advice. If you’re not sure whether an investment is right for you, then seek advice. Investments and any income from them will rise and fall in value, so you could get back less than you invest. Ratios also shouldn’t be looked at on their own.
What is the P/E ratio and how does it work?
One of the most common valuation measures is the forward price-to-earnings ratio, usually shortened to forward P/E.
Forward P/E compares the current share price with the underlying earnings per share that a company is expected to generate during the next 12 months, on a diluted basis. It shows how much investors are willing to pay today for each pound of expected annual profit.
Two definitions matter here. just
A trailing P/E uses profits that a company has already reported, so it deals in facts but looks backwards. A forward P/E uses forecasts, so it looks ahead but relies on estimates that can be wrong.
We’re looking just at the forward version here, our preferred measure. And by underlying earnings, we mean profits stripped of one-off items like restructuring costs or disposal gains, as is normal for forecasts.
The calculation is simple:
Share price ÷ expected earnings per share = forward P/E ratio
The ratio is worked out from the share price, not the other way round. But if you turn it around, it can be a useful way of breaking down what investors are paying for and to see what would need to change for the price to move.
Expected earnings per share × forward P/E ratio = implied share price
Share price performance can therefore come from two places:
Expected earnings per share can rise
Investors can become willing to pay more for those earnings
The strongest returns can come when both happen together, but the reverse is also true.
What drives changes in a company’s P/E ratio?
Two things are worth flagging before we go further.
Earnings per share don't rise only when profits rise. Because it's profit divided by the number of shares, buying back and cancelling shares lifts it even if profits stand still.
And share price isn't the only thing that matters. Dividends can sit alongside share price growth, so a company can deliver a decent total return without much movement in the share price at all.
Let's explore how this works in practice. The examples below are illustrative only – they hold the number of shares constant and ignore dividends to isolate the two drivers.
First, earnings expectations.
Imagine that a company is expected to earn £1 per share in the next 12 months and trades on a forward P/E of 20. That would imply a share price of £20.
Now suppose that analysts upgrade their forecasts and expected earnings rise by 20% to £1.20 per share. Let's assume that investors still consider the company's strength broadly unchanged, so they still apply the same 20 times earnings multiple.
The implied share price rises to £24 (£1.20 × 20), a 20% gain. Investors are applying the same valuation to the company but to a higher level of expected earnings.
Then, the multiple.
The forward P/E ratio, often just called the multiple, captures how highly investors value those expected earnings.
Returning to our example, if expected earnings stay at £1 per share but the forward P/E rises from 20 to 24, the implied share price also rises to £24 (£1.0 x 24), again a gain of 20%.
Same price, same percentage move, but for an entirely different reason.
An increase in the valuation multiple is known as a re-rating. It can happen when investors become more confident about a company’s future growth, competitive position or ability to deliver reliable profits. Falling interest rates or improving sentiment towards an industry can also encourage investors to pay higher multiples.
A de-rating is the opposite. If investors become less confident, then they might be willing to pay only 16 times expected earnings instead of 20. Even if earnings expectations remain unchanged, the implied share price could fall (£1.0 x 16 = £16)
This is why a low forward P/E does not automatically mean that a share is cheap. Investors might expect future earnings to fall or doubt whether current forecasts can be met. Equally, a high forward P/E does not automatically mean that a share is too expensive. Strong growth, dependable revenues and resilient cash generation can justify a higher valuation/multiple.
When the earnings and multiple move together
The biggest share price moves can happen when earnings expectations and the forward P/E change at the same time.
If our example company’s expected earnings rise from £1 to £1.20 per share and its forward P/E increases from 20 to 24, then the implied share price would reach £28.80 (£1.2 x 24). That’s a 44% increase, despite expected earnings and the valuation multiple rising by only 20% each.
But suppose expected earnings increase to £1.20 while the forward P/E falls from 20 to 16. The implied share price would be £19.20, which is 4% below where it started. The company is expected to earn more, but investors are no longer willing to value those earnings as highly.
That distinction is important when assessing a company's potential to outperform.
Sometimes the opportunity rests mainly on earnings. Strong earnings growth can be a powerful tailwind even if the multiple stays where it is.
In other cases, the earnings outlook might already be well understood but the shares trade on a lower multiple than similar businesses or than the company's own long-run average. If the reason for that discount fades, the multiple has scope to rise.
The best opportunities offer both rising earnings and scope for the multiple to expand. But if we had to pick, we would prefer companies where earnings growth does the hard work, because a re-rating depends on sentiment shifting and that’s far harder to forecast than profits.
The forward P/E is not a crystal ball
A forward P/E is based on forecasts, not guaranteed profits. Those forecasts can change as trading conditions, costs, competition and the wider economy evolve.
Comparisons are also most useful between similar businesses or against a company’s own history. A fast-growing technology business will often trade on a higher multiple than a mature company with limited growth. That does not automatically make one expensive and the other cheap.
The measure has hard limits, too. It stops working altogether for loss-making companies, where the ratio is either negative or meaningless. And because it looks only at the share price, it ignores the balance sheet, so two companies on identical multiples can carry very different levels of debt.
The forward P/E is best treated as a starting point rather than a complete answer. Investors need to consider whether earnings forecasts look achievable, what could cause them to change, and whether the current multiple fairly reflects the opportunities and risks.
Our research team considers valuation multiples, the earnings outlook, company-specific risks, and more when producing our regular research updates. To get these updates direct to your inbox, consider signing up to our share research.
This article is original Hargreaves Lansdown content, published by Hargreaves Lansdown. It was correct as at the date of publication, and our views may have changed since then. Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by LSEG. These estimates are not a reliable indicator of future performance. Past performance is not a guide to the future. Investments rise and fall in value so investors could make a loss. Yields are variable and not guaranteed.
This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment.