In our ‘How to Invest in Shares‘ article, we identified financial ratios as a key method of analysing companies. While I personally follow a passive model of investment, by investing mainly in index funds, I can see the glamourous appeal of investing directly in companies and making a judgement on their financial future. Below I will discuss one of the most popular ratios used to analyse the stock market – the Price to Earnings ratio.
The Price to Earnings Ratio, or ‘P/E’ ratio is calculated by dividing the price of a share by the earnings per share (EPS), you can find both these figures on Google Finance.
This metric, express as a simple number e.g. ’15′, shows what investors are prepared to pay for every £1 of a companies earnings. This reflects the stock market’s view on the risk of the company, and the outlook for the company.
A Measure of Risk
The lower the risk of an annual cash flow, the higher investors are prepared to pay for it. A good example are government treasury bills, which offer a measely yield of between 1%-3% due to the high value that investors place upon these ‘risk-free’ earnings. In contrast, an investor will place a far lower valuation on the earnings of a company which experiences wild volatility and even produced losses in some years.
A Measure of Outlook
If a troubled industrial giant e.g. General Electric shows signs of weakness in the face of emerging markets competition, investors may take a dim view on GE’s outlook, and will not be prepared to place a high price on the companies earnings, as the earnings stream may drop off in the next few years. The share price of GE dropped to below ’10′ during the 2000-2010 decade as GE’s corporate earnings began to slip.
On the other hand where the outlook on growth and earnings is fantastic, a company will have a higher P/E. A good example of this in action are the valuations of technology newcomers Facebook, LinkedIn and Groupon. In these cases, investors have been prepared to pay an (almost ridiculous) multiple of earnings, because they believe that those earnings will multiple many times in the future. Therefore in recent IPOs, investors have been pricing companies at over 100 P/E. At this price, every £1 they invest will only generate only 1p in earnings if the company remained at its current level of profitability. Investors are clearly confident that earnings will rise so drastically that they’ll soon be earning 20p in earnings for each £1 originally invested. Whether that will happen remains to be seen. Personally I am always alarmed by P/E ratios above 30-40, and I interpret it as a sign of a bubble.
How to Use the P/E Ratio
The best way to use the Price to Earnings ratio is to compare your target company relative to its competitors. The PE ratios of companies in different sectors tend to be very different due to the different inherent risks and outlook of each industry. However when used to compare against similar size peers, you can begin to see which firms have a more favourable market outlook than others.
Investing in companies with the highest P/E ratios is not necessary a great strategy, neither is investing in companies with very low P/E ratios. Using the ratio alone to make your investment decision is not advisable. This is because investors place different values on different earnings for good reason. This means that a low P/E doesn’t necessarily mean the company is undervalued, indeed it may still be overvalued if its true value is almost worthless.
The implications of this are that you need to form a judgement of what the P/E or value of the company really is. You can then compare this to the actual P/E and determine whether to purchase the shares or not. Try researching around on news sites to pick up indicators of ‘why’ a P/E is where it is. If you agree with the judgement of the investors, perhaps you may conclude that the value of the company is reasonable afterall.
Practical Issues with the P/E Ratio
You should be careful when analysing the P/E ratio of companies without looking at the longer term picture in terms of earnings. If you only use the prior year earnings figure in the calculation, then a sudden (but temporary) dip in earnings will lead to the P/E ratio rocketing up. This is because when the market appreciates that a dip in earnings was only temporary, the share price won’t move much to compensate.
As hinted above, the P/E ratio only tells you what is, but not ‘why’. With multiple factors feeding into the metric, you will have to partake in further research to attempt to reason why the market places a different price on the earnings to you.
The stock market moves up and down in step with economic sentiment. Whilst this is usually because a poor economic outlook will affect the earnings of each individual company, there are many cases where a company who shouldn’t be heavily affected by economic news, is ‘brought down’ as sell offs occur across the whole market. In this respect, the volatility of share prices undermine the informational value of the P/E ratio on any given day.