Price-Earnings-Ratio: A Useful Ratio To Understand
Price-Earnings-Ratio is a very useful ratio. This article on P/E ratio attempts to explain
the following:
- The definition and formulae,
- Salient points noted in the interpretation of P/E ratio,
- Are there any limitation of using P/E ratio,
- An illustration of using P/E ratio in the same industry,
- Using Prospective P/E ratio to test for future profit
- P/E ratio as a method or basis to value share in M&A ( to be separately cover in another article in the Merger & Acquisition’s column)
Definition and Formula Of A P/E Ratio?
The price-to-earnings ratio enable us to understand:
- how much money we are paying for $1 of the company’s earnings. In other words, if a company is reporting a net earnings of $4 per share, and the stock is selling for $20 per share, the P/E ratio is 5 because you are paying five times earnings ($20 per share divided by $4 per share earnings = 5 P/E).
The formula for this P/E ratio is as follows:
- Market Price per share divided by Earnings Per share
Some Salient Points In The Interpretation Of P/E Ratio:
The following are some of the salient points to note:
- For us to know what is a normal P/E, we need to know the particular sector’s average P/E This sector’s average P/E should reflects the speed of expansion in that industry, how cyclical it is – industries that traditionally move from boom to bust every 6 to 10 years tend to have rather low P/Es – and its rate of technical renewal. Average P/Es also shift depending on the position in the economic cycle. Construction company shares will be far more highly valued as we enter an upturn than they are with a slow-down approaching,
- It’s worthwhile watching for the highest or lowest individual P/Es within each sector to spot for any good “buy”. This happens when some temporary unfounded rumor has impacted a company’s share price giving an abnormal low P/E but the fundamentals are still intact.
- If a P/E is lower than the norm for a sector, the share is at a discount – it’s relatively cheap. Conversely, when an individual P/E is higher than the norm, the share is at a premium, that is, relatively expensive,
- We need to note that different industries have different P/E ranges which can consider as “normal”. Say the technology companies which denote higher growth prospects which can sell at an average of 40x P/E, while textile manufacturers which normally have dismal margins or plain earnings may only trade at an average of 8x.These differences between sectors are perfectly acceptable. They arise out of different expectations of the earnings prospect for different businesses.
- One way to know when a particular sector say for example the advertising, utilities, etc is over priced is when the average P/E ratio of all of the companies in the industry is far above the historical average. If we do not take note of this, we can land ourselves in trouble. This actually happened in the late 1990’s where gross-over pricing appeared in the dot-com companies. Perhaps, the investors during that time could have avoided the huge declines in the technology stocks had they sold the stocks the moment they realized that the entire industry was dangerously expensive.
6. As P/E ratio has no cut-off for what is high or low, we should only know it as as a normal and abnormal ratio. By familiarizing with the normal P/E in each different sector, we can then use the abnormal to get straight to the places where share prices are most definitely moving out of step.
Limitations In The Using Of P/E ratio:
The P/E ratio is just a ratio, a very low P/E ratio does not necessarily mean that the share price is low and therefore we can buy it. We really need to know the reasons and the validity of the reasons for the low P/E ratio. For example, the following should at least be included in your investigation of the low P/E ratio:
- Is management honest?
- Are they losing key customers?
- Is the Board of Directors buying stock in the company?
- If the weakness is across the entire sector or just because of temporary bad news that doesn’t change the bottom line, then consider buying.
Vice versa, a very high P/E ratio can means a lot of other things like:
- Can it be a result of a rumored take-over,
- Are the share price being unjustifiably supported by some small shareholders who are reluctant to sell,
- Is it really because of market’s confidence in a company’s new product that’s set to be a blockbuster,
An Illustration Of Using the P/E Ratio To Compare Companies In The Same Industry
| Earnings Per share | Current Market Share Price | P/E Ratio | |
| Company A | $10 | $60 | 6 x |
| Company B | $20 | $60 | 3 x |
It’s important to understand that though both companies are having the same market share price of $60.00, they have different P/E ratio. Here, company A has a P/E ratio of 6 whilst B has 3x .
So How Do We Interpret This Illustration:
We can say that the market price of the share of Company B is much cheaper on a relative basis as a result of the lower P/E ratio.
For every share purchased, we are getting $20 of earnings as opposed to $10 in earnings from company A.
All else being equal, we should opt to purchase shares of Company B; for the exact same price ($60), as we are getting twice the earning power.
Using Prospective P/E Ratio to test for future earnings or profits:
Computation:
We can test the future earnings or profits of a company by using a Prospective P/E ratio which is the:
Current share price divides by forecast earnings per share. The forecasts can be based on the next year, and even the following years earnings records.
Illustration:
| Current Year(CY) | CY +1 | CY+2 | |
| Current & Forecast Earnings per share | $10 | $40 | $50 |
| Price per share |
$100 | $400 | $500 |
| P/E & Prospective P/E ratio | 10x | 2.5 x | 2 x |
Interpretation:
- If next year’s profits are on target and is significantly higher than the current year’s profits, the prospective P/E ratio will be then be lower than the current P/E ratio. Generally, this applies to companies and sectors which are in take-off or rapid growth,
- However, it is interesting to note that generally the market would have discounted this by already valuing the share price of the company higher by putting up an abnormally high current P/E ratio. This is just to reflects the future profit levels,
- So you might notice that for the above illustration, in the Current Year (CY), the share price might have gone up to maybe say $400 per share or even more.
6. As P/E ratio has no cut-off for what is high or low, we should only know it as as a normal and abnormal ratio. By familiarizing with the normal P/E in each different sector, we can then use the abnormal to get straight to the places where share prices are most definitely moving out of step.
- Market To Book Ratio
- Financial Ratios on Assessing The MARKET VALUE Of A Company
- Altman Z System: Financial Ratio To Forecast Bankruptcy
- Ratio Analysis: Which Ratios Have the Most Value?
- Dividend Payout Policy: Does It Affects The Company’s Share Price? (Part 1)
- Ratio Analysis : What Other Factors, Beyond Ratios, Need To Be Considered?
- IPO Price – How Fair Is It?
April 13, 2006
Posted in: Ratio Analysis
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