Understanding Pe Ratios

 

 

MoneyVidya.com Investor Essentials: P/E Ratios, what are they and what do they mean?

Tuesday, 07 April 2009   

 

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  Introducing the P/E ratio The P/E, or price-to-earnings, ratio is one of the most important metrics for an investor as it describes the true price of a stock. The ratio measures the relationship between market price and current profits (earnings) and can be calculated as follows; /

, where EPS = Earnings per share

For example if a stock trades at 20Rs and current Earnings Per Share (EPS) is 2Rs, the stock has a P/E ratio of 20/2 = 10. This could also be calculated by dividing market capitalisation by total profits. The P/E ratio expresses the cost of purchasing the right to one unit of profit. For example, a P/E ratio of 10 means that based on the current levels of profitability an investor must pay 10 units in order to acquire the rights to 1 unit of profit. A higher P/E ratio means investors pay more per unit of profit than a lower P/E ratio.

Why do stocks have different P/E ratios? Ownership of a stock implies the (somewhat theoretical) right to a share of future profits. Differences in P/E ratios generally represent a risk premium being applied to the earnings of one company versus another, due to uncertainty around the future. For example, if company A and company B have the same EPS but company A is expected to double its profits next year, while company B is expected to have static profits, then company A will trade at a higher price. Because both stocks have the same EPS, but company A trades ar a higher price, company A has a higher P/E ratio. Typically a stock which is expected to grow profits in the future, will trade at a higher P/E ratio than one which is expected to have static profits. Similarly a company with secure (low risk) future earnings will have a higher P/E ratio than a company with unsecure (high risk) future earnings. In this sense the P/E ratio expresses marketss confidence in a stock’s future earnings.

What is a high P/E and what is a low P/E? As an extreme gnerality, for a market as a whole, P/E ratios below 8 is considered to be on the low side, P/E ratios between 8 and 20 are often to be considered to be fairly valued while P/E ratios above 20 indicate the stock is highly valued (or over valued).

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However these are broaad generalisations and can be dangerous to rely on. Investors should not just look at P/E ratios for stocks in isolation as different sectors tend to have different P/E ratios. For example a P/E ratio which would be considered low for a small and immature communications company may not be considered low for a large oil refining business. A quick and simple way of using P/E ratios is to compare a stock’s P/E with the P/E ratios of its competitors, the average P/E ratio for their sector and the market average. This gives a good indication of how the market views the stock in relation to others.

Using P/E ratios to make investment decisions Although P/E ratios are extremely important, two pieces of information should be remembered; Firstly, the right to future profits implied by owning a stock does not in itself generate income for the investor. The actual return earned on a stock depends on the future sale price and the dividend yield, which is determined not only by earnings but also the company’s dividend policy. Secondly, in most circumstances the current market price has already taken account (factored in) expected future earnings. This means that in order for the price of a stock to rise (over a prolonged period of time) the current earnings expectations must be exceeded by the firms actual performance or future expectations should be higher than current expectations, for some other reason. The key point to remember is that a high P/E ratio may imply earnings are expected to rise in the future, but if they do rise this does not automatically mean the price will also rise. This is because the increase was expected and already factored into the price. Because of this, investors often shy away from stocks with extremely high P/E ratios (25+) because in order to make a decent return, the company must improve upon the already extremely high expectations. In fact value investors, such as Warren Buffet specifically look for stocks which are under priced and often invest in stocks with low P/E ratios (although this is by no means the only criteria). The important thing to remember is that the P/E ratio of a stock is the true measure of price and even an extremely good company may be a bad investment if the price is too high.

Tuesday, 07 April 2009   

 

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