Value investors and non-value investors alike have long considered the price-earnings ratio, known as the p/e ratio or PER for short, as a useful metric for evaluating the relative attractiveness of a company's stock price compared to the firm's current earnings.
Made popular by the late Benjamin Graham, who was dubbed the "Father of value investing" as well as Warren Buffett's mentor, Graham preached the virtues of this financial ratio as one of the quickest and easiest ways to determine if a stock is trading on an investment or speculative basis, often offering some modifications and additional clarification so it had added utility when viewed in light of a company's overall growth rate and underlying earning power.
As you discover how useful the P/E ratio can be, however, keep in mind that you can't always rely on price-to-earnings ratios as the be-all and end-all yardstick in determining whether a company's stock is expensive. There are some significant limitations, partly due to accounting rules and partly due to the inaccurate estimates most investors apply when projecting future growth rates.
We take a look at the Price Earning Ratio and examine what a high or low P/E ratio can tell us about a company’s share price.
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The price-earnings (PE) ratio or PER measures the current share price of a company relative to its earnings. It is also known as the price multiple, or the earnings multiple, and shows how much an investor is prepared to pay for each £1 of a company’s earnings.
The fundamental investor uses a selection of tools to determine whether a share price is overvalued or undervalued. The P/E ratio is one of these, and while it is one of the most commonly used, it is also one of the most useful, narrowing down the universe of possible investable choices.
The P/E ratio is calculated by dividing a company’s share price by the earnings per share (EPS) figure. If a company’s EPS is $20, and the share price is $140, then $140/$20 equals seven, suggesting that an investor will be $7 for each $1 of EPS.
The P/E Ratio formula:
The advantage of a Price Earning ratio, like many other formulae in investing, is that it allows an investor to compare different companies using one simple calculation. For example, there are hundreds of companies in the two main UK indices alone, and pouring over their financial statements would take hundreds of hours. But filtering using a P/E ratio allows an investor to reduce the choice to a smaller number, removing those based on a particular criterion.
For some investors, a high PER might be deemed attractive. A higher PER suggests high expectations for future growth, perhaps because the company is small or is a rapidly expanding market. For others, a low PER is preferred, since it suggests expectations are not too high and the company is more likely to outperform earnings forecasts.
Buying a stock is essentially buying a portion of that company’s future earnings. Companies that are expected to grow more quickly will command a higher price for their earnings. Earnings per share can be either ‘trailing’ or ‘forward’, with the former taking into account the earnings from the past few years, and the latter relying on estimates. A company with a high trailing Price Earning ratio may be viewed as having a more reliable record than one where the forward Price Earning ratio is in its twenties.
Defining an ideal P/E ratio is difficult. As with so many things in financial markets, it is difficult to apply a firm rule. A good way of helping to understand a company’s valuation is to look at it in the context of the broader stock index, or of the sector in which the company operates.
For example, a P/E ratio of 15 for a house building company means little unless an investor finds that the average P/E ratio for the housebuilding sector is 27. Then the company is cheap relative to the broader sector and may see outperformance as it exceeds expectations. Or a company with a high P/E ratio relative to the sector may struggle if it fails to meet forecasts.
Price Earning ratios change over time, and, like trend following in technical analysis, a company may have periods when it is overvalued and undervalued by the market.
At the peak of the internet/technology bubble of the 1990s, the stock market as measured by the S&P 500 Index was trading at a P/E ratio of close to 40. To date, this is an all-time high for that ratio.
At the bottom of the worst bear markets, the stock market (S&P 500 Index) has traded at a P/E ratio of close to 7.
The average P/E ratio of the market is about 14.
It is arguable that a PER of five or less is not a remarkable bargain. While it might look as if the company’s prospects are being viewed too negatively, it is not a bad rule of thumb to filter out companies with a PER below this level. It suggests that the future outlook is quite bleak and that there are far too many problems facing management.
A very high Price Earning Ratio is not necessarily a warning sign that expectations have become too high. To take a classic example, Amazon trailing P/E ratio climbed from over 70 at the beginning of 2011 to 130 by the middle of the year. But the stock climbed 46% in that same period and rose relentlessly over the next five years. If a firm can meet the expectations implied in a high P/E ratio, then it can pay off.
The Price Earning Ratio is a useful starting point. It is not the beginning and the end of an investor’s investigations into a company. It can overstate the positives as well as exaggerating the negatives. It also does not consider vital information such as the dividend yield, the level of debt at a company, management changes, and a host of other issues.
However, when faced with hundreds, if not thousands, of different companies, filtering by the Price Earning Ratio can be a good way of narrowing down the universe of options. It then allows an investor to put more effort into finding out more about specific companies in a sector. While it is possible to construct a stock investing strategy based purely on the Price Earning Ratio, it is perhaps better thought of as a first step along the road to making an investment in a specific company.
In the early 70s, there was a group of stocks called the Nifty Fifty. These were fifty of the largest companies listed on the stock exchange, and institutions bought giant-sized positions of their stock. As stock prices soared, the Price Earning ratios of these companies grew to highs in the range of 65-92. The stock market crash of 73/74 came along, and by the early ’80s, these same companies had Price-earnings ratios of 9 to18.
No sizable company can continuously increase their earnings fast enough to justify that level of investment. The lesson wasn’t learned, however, and the situation repeated itself in the late ’90s with tech stocks. P/E ratios of the tech favorites routinely exceeded 100. Some companies had no profits, yet, commanded higher ratios compared to more conservatively run companies.
The lesson to be learned is that abnormally high P/E ratios, combined with exuberant headlines, can be a signal that the market is overheated and equity exposure should be reduced. Abnormally low P/E ratios, combined with pessimistic headlines, can be a signal that equity prices could be "on sale."
The price/earnings ratio (P/E ratio), also known as an “earnings multiple,” is one of the most popular valuation measures used by investors and analysts. The basic definition of a P/E ratio is the stock price divided by earnings per share (EPS). The ratio construction makes the P/E calculation particularly useful for valuation purposes, but it's tough to use intuitively when evaluating potential returns, especially across different instruments. This is where earnings yield comes in.
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