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What is P/E Ratio?
P/E ratio stands for a price-earnings ratio. This is a measure that reflects the price of a company's share compared to the earnings per share. Why is this important to investors?
Well, briefly the P/E ratio shows how much should an investor pay for $1 of a company's earnings. The higher the ratio, the more an investor should pay for the company's earnings.
Importance Of P/E Ratio
Let's start with an example:
Assume you want to invest in a company whose current share price is $15 and the company reported for the last 12 months a $2.5 earnings per share. Then divide 15 by 2.5 and you will get 6. So, the P/E ratio is 6 in this case.
Keep in mind that people usually prefer to use the diluted earnings per share when calculating. The diluted earnings include also the impact stock option grants or convertible bonds have on a company. By doing so, you can easily find out how much of a return you can get from investing in a company.
But here’s the most important part:
Most financial portals will help with the calculations and give you the expected P/E ratio. Once you have it, you can start making your bets- which stocks are worth it. Don't be fooled by the high P/E ratio some stocks have (check below the P/E bubbles). It doesn't necessarily mean a solid performer. On the other hand, do not underestimate stocks whose ratio is currently low.
Calculate The P/E Ratio
There are two types of P/E ratio: Trailing 12 Months (TTM) and Forward P/E.
- TTM– divide the current share price of a company by the earnings of the same company in the last 12 months.
- Forward P/E– divide the current share price of a company by the future (expected) earning of the same company in the future 12 months.
For example, company Y has recorded earnings for the last 12 months of $10 million. The company has 1 million shares. First, we have to find out how much the earnings per share is. We divide $10 million by 1 million shares and we have $10 per share. Let's assume that the current share price is $3.5. Price per share/Earnings per share is our P/E ratio. $3.5/10 =0.35.
So, company Y's TTM is 0.35. In case the company has no earnings, which means it generates losses, there is not P/E ratio listed. As a rule, companies list only positive P/E ratios.
How To Compare Companies Using P/E Ratio?
Investors know how and when to use the P/E ratio, especially to compare two companies in the same industry. It is also an indicator that shows which companies are over- and which undervalued. Very often two companies have the same share prices– let's say $50. However, the P/E ratio will show which one is actually more expensive, depending on earnings, profits, and growth.
For example, we have two companies (Y and Z) which have the same share price – $50 apiece. Company Y has reported $11 earnings per share; company Z has reported $6 per share.
Company Y's P/E ratio is 4.5 ($50/$11=4.5) and company Z's same indicator is 8.3 ($50/$6=8.3). All this shows that the first company is generally cheaper because its P/E ratio is lower. For the same price, an investor in company Y will receive much more.
High or Low P/E Ratio – Which Is Better?
If we strictly follow the above-listed example, we can safely assume that the lower the ratio, the cheaper the asset.
As in the example, the same share price does not mean the same company performance. If two companies have an equal P/E, this does not mean they are equally attractive as an investment. There are other factors that matter when a person evaluates a company's earnings, performance, etc.
For example, let's take a company's intrinsic value. This is a term that refers to the value of a stock or a company based on fundamental analysis. This is not the company's market value. Certainly, two companies which have an equal price-to-earnings ratio will not have the same intrinsic value. This will eventually lead to differences in the performance of the two companies. In addition, different companies use different accounting procedures, which can affect the results.
Sometimes companies have accumulated debt.
Another example is when a company has brighter future prospects– earnings, expansion, investments. If you compare it to a less prospective company with the same current earnings, you will definitely know which one to choose.
But that’s the point:
Different sectors perform differently, but sometimes trends affect all the companies in the respective industry. What is the expected growth in the energy industry? The decline in oil prices in 2014 and 2015 generally had an impact on all companies within the sector.
The 1970s P/E Bubble
History is written to remind the winner of their victories, and the losers of their losses. In business terms, history helps to understand past mistakes and learn from them. In the past, there were several P/E ratio bubbles– the 70s, 90s,
One of them happened in the 70's. A group of 50 most popular stocks listed on the New York Exchange became known as Nifty Fifty. These were prospective stocks from large-cap companies. They attracted numerous investors and as a result of that their prices increased significantly. This process reached its height in 1973-74, when the market collapsed.
Prior to that, the P/E ratios of these stocks hit unseen levels 70-80. Of course, after the crash, their ratios dropped by 40-50.
Investors' mistake was to believe that a company can exponentially grow and expand its earnings each year.
The 1990s P/E Bubble
Again in the 90s when the world saw overwhelming developments in technology, the bubble repeated itself. Technology companies stocks hit P/E ratios above 90, sometimes up or more than 100. That would not be so surprising if those companies had been stable and financially sound.
In conclusion, I can say that high P/E ratios have to be analyzed carefully. Is the company sound and has future growth potential? Is it the only one in the whole sector or almost all companies regardless of their results share high ratios?
Other Useful Indicators
When an investor wants to assess a company or a whole sector to invest in, P/E ratio is not the only one. You remember that stocks with a low P/E ratio do not promise high returns. On the other side of the coin, high-priced stocks might be a signal of future collapse.
One of the other indicators you can use is the so-called Price/Earnings to Growth Ratio (PEG). This metric reflects the price of a stock and its earnings but also includes a company's expected growth.
PEG Ratio = (Price/Earnings Per Share) by Annual Earnings Per Share Growth.
Another metric that comes in handy is the Dividend Adjusted PEG Ratio. This major financial tool is based on the PEG indicator but also takes into account the dividend income per share.
Dividend Adjusted PEG Ratio = (Price/Earnings Per Share) by (Annual Earnings Per Share Growth + Dividend Income).
Key Points When Evaluating P/E ratio
Let's summarize the previous paragraph and outline the key points in P/E evaluation:
- To begin with, try to compare companies that are in the same market. Do not compare a business in the energy sector with one in the marketing industry. Choose similar companies and then you can start a more precise assessment.
- Stocks with low P/E ratio does not indicate that the price will soar and reach the normal in the sector. It might happen only if there is supporting evidence– good performance, for example.
- Keep in mind that the overall condition of the economy could be a driving factor in some industries, in particular. Try to remember this, especially if you want to evaluate high-performing stocks. Often, stock prices rise because of the overall performance of the respective sector not because of a single company.
- High P/E ratio does not fool good investors. They know that they have to follow closely the performance of a business for a long period of time. Include in your assessment the overall conditions of the economy. Also, related any future plans of the company to expand or do some changes in its policies.
To conclude, both experienced and new investors use the P/E ratio of a company as a basis when deciding where to invest. However, deeper market knowledge can also help you as well as understanding main economic principles.
This includes other parameters such as PEG ratio and Dividend Adjusted PEG Ratio. Don't forget that P/E ratio can often signify a bubble within a specific market, which might collapse in the future.