The ratio
Price-to-earnings (P/E) compares a company’s share price to its earnings per share. Roughly: how many dollars you pay for one dollar of annual earnings. A P/E of 20 means you are paying $20 for $1 of earnings (trailing or forward, depending on which earnings you use). It is a speedometer reading, not a full diagnostic.
Trailing vs forward
Trailing P/E uses earnings already reported. Forward P/E uses estimates for the next year. Forward numbers embed optimism or pessimism that can be wrong. Always notice which version you are looking at before comparing two companies — mixing them is how “cheap” and “expensive” arguments talk past each other.
Not a grade by itself
A “cheap” P/E can mean the business is in trouble and earnings are about to fall. An “expensive” P/E can mean investors expect rapid growth and are willing to pay up. Sometimes a low P/E is a value opportunity; sometimes it is a trap.
Always ask: cheap or rich compared with what — the company’s own history, its peers, or the whole market? A number without a comparison is just trivia.
What P/E misses
Debt levels, cash on the balance sheet, one-off earnings spikes, different accounting, and entire business models where earnings are temporarily reinvested away. Some firms are better compared with enterprise-value ratios or cash-flow measures. P/E is a starting flashlight, not a full inspection. Useful in a dark room; insufficient for a house survey.
Example
Company A trades at 12× earnings but is losing customers. Company B trades at 28× earnings but is growing profits 20% a year with a strong moat (a durable edge that is hard for rivals to copy). A is not automatically the bargain. The multiple has to be read next to the growth and risk story — otherwise you are shopping by price tag alone and ignoring whether the product still works.
Why this matters for fund investors
Even if you only buy index funds, valuation still matters at the market level: expensive markets can mean lower expected future returns, though timing that call is hard. Use valuation as context for expectations, not as a weekly trading trigger. Knowing the yardstick is rich or cheap helps you stay calm — it does not mean you must act on every reading.