The price/earnings ratio (P/E ratio) is commonly used to assess the level of confidence investors have in a company. It represents the market's view of a company's growth potential. Investors try to identify undervalued stocks by comparing P/E ratios between companies and across business sectors.

A high price/earnings ratio indicates that investors have a high level of confidence in a company's future. But while a company with a high P/E ratio relative to its sector may have exciting growth prospects, it might equally be considered to be overvalued depending on the prevailing market circumstances. So while P/E can be a useful measure of a company's value, it should also be treated with caution.

How is the P/E ratio calculated?

To calculate P/E ratio, divide the stock price by the post-tax earnings per share (EPS). To calculate earnings per share, divide a company's 12-month earnings by the number of outstanding shares.

If a company's earnings are £2 million and the number of outstanding shares is 1 million, it has an earnings-per-share figure of £2.

Now you can work out the P/E ratio by dividing the stock price by the EPS. So if the stock price is £30 and the EPS is £2, then the P/E ratio is 15.

Using the P/E ratio

Like most performance indicators, the P/E ratio is most revealing if it is monitored over a long period. That way, it is possible to uncover trends rather than relying on snapshots of a given moment.

When using P/E to analyse companies, always use consistent information. Most P/E figures are reported using 'trailing' earnings (ie, the earnings for the past 12-month period). But some brokers report P/E figures on 'leading' earnings (ie, the projected earnings for the next reporting period).

It's also wise to eliminate any one-off gains or losses when comparing P/E ratios so that you can arrive at an accurate earnings figure.

New valuation measures

P/E ratios vary dramatically between sectors. For example, the high-tech economy has seen high valuations of companies that are making huge losses. Some brokers have even begun to calculate negative P/E ratios in order to compare these companies. Other brokers simply refuse to quote a P/E ratio for a loss-maker.

Companies have traditionally been valued using P/E multiples, but it is now commonplace to value companies on the basis of projected turnover - even though they may be making big losses. Meanwhile, high-tech companies that are actually making money carry extremely high P/E multiples.

These measures are a long way removed from standard practice, and their usefulness is questionable. It is vital to exercise discretion and apply balanced judgment when relying on P/E multiples for investment decisions.