The Price-Earnings – or PE – ratio is used very often by investors and financial analysts to gauge the price level of any given company’s stock. It is the ratio of the price of the stock to the earnings per share of the company in any given year. In very broad terms, all else being equal, the lower the PE of a share, the cheaper it is considered to be, and the higher the PE, the more expensive it appears. This is a very broad brush. All else is not equal. And you can’t apply this ratio blindly to choose attractive stocks, nor can you create a rigid filter to come up with a shortlist of cheap stocks based on just the PE ratio. Nonetheless, it can be a useful tool as part of the overall securities analysis toolkit.

The reason it is useful is that it provides a baseline measure of the value you are getting for the price that you are paying, especially if the ‘E’ in the PE is actual historical earnings that have been earned by the company. 

If we flip the PE ratio around, we get something called the earnings yield – the earnings as a percentage of the asking share price. Again, all else being equal, we can compare the earnings yield to other assets and even asset classes to gauge the value we are getting for the price being paid.

A PE of 8x means that the earnings yield is 12.5%. A PE of 40x means the earnings yield is 2.5%. 

Given all the other factors that go into investment analysis, the earnings yield can give the analyst a sense of how safe or stretched the valuation of a particular potential investment could be. For example, how much does a conventionally richly valued company need to grow earnings to make the rich valuation an attractive one? 

The earnings yield can be used as a rule of thumb, a gut check against other alternative assets that may be available at different earnings yields and accompanying risk profiles. The percentage earnings yield crystalizes the comparison for the analyst in a way that the inverse ratio, the PE, somehow doesn’t.