Friday, 8 August 2014

Investment Basics: What is the P/E ratio?

Any investment book that deals with stocks (see a few of my recommended ones here) will mention the P/E ratio of a company (Price to Earnings Ratio).  Most of them take it for granted that you know what it means and if they do explain it, it tends to be at a very high level.  This post will break down the P/E ratio so that the next time you are looking at a stock you know what you are actually looking at when you look at the ratio.

The P/E ratio is a relative measure of how expensive a stock is

That's actually all a P/E ratio is.  People often assign all sorts of interpretive power to a P/E ratio but in fact it provides nothing more than a tool for comparison with other companies.

The P/E ratio of a company looks at the price you are paying for every dollar the company earns.  I will go into more detail about how the P/E ratio is calculated and what it is and isn't useful for below:

How is the P/E ratio calculated?

Of all the ratios that investors use to value stocks, the Price to Earnings ratio is one of the easiest to calculate.  It is simply:
The price of one share in the company / The earnings per share of that company
Each of these is reasonably easy to find:

  • The price of the share is usually stated on a stock exchange and it is easy enough to look this up on the internet
  •  The earnings per share is usually stated in the companies earnings report (it is normally highlighted because they know that investors look for it

What does the P / E ratio mean?

This is the part which most people trip up on.  The P/E ratio in isolation actually tells you nothing.  Just knowing that a company has a P/E of 12.5x tells you nothing about that company and it definitely doesn't tell you whether the share is cheap or expensive.

The P/E ratio is used to compare the relative price of different companies to each other.  For example if there were two identical companies in every respect and one traded at a P/E of 10.0x and the other at 12.5x you would be able to say that the first one was cheap relative to the second one.

Are you starting to see some downsides to the P/E ratio?

When you realise exactly what the P/E ratio actually is some downsides and limitations start to become clearer.  They include the following:
  • Companies are priced on future earnings potential and growth not past earnings.  Using a historic earnings number can make a stock look really expensive or really cheap even when it isn't.
    • For example if a company made good profits last year but a new product has entered the market which are going to really eat into it's market share and profits the share price will adjust to reflect the fact the company isn't going to make as much money going forward.  The problem with using last years earnings is that it now makes the company look really cheap...even when there is a reason for it to look cheap
    • The problem you now have is that you have to start estimating future earnings which is a much harder thing to do
  • You cannot compare companies in different industries
    • Companies in different industries have different risk profiles, earnings potential and growth prospects.  It simply doesn't make sense to compare the P/E of a utility to that of a retailer or an internet company.  It is too simplistic a measure
    • When you are using the P/E ratio to compare companies they have to be in the same industry
  • Even companies within the same industry have differences
    • There are reasons why different companies are priced at different prices.  Should you value a company that has the risk of a large litigation bill the same as one that does not?  Probably not but the one with the large litigation bill would look cheaper if you just used a simple P/E analogy
  • The level of debt (or gearing) affects the P/E ratio even within two identical companies
    • The more leveraged a company is the cheaper it is going to look on a P/E basis alone.  This is because companies with more debt tend to have less equity (less shares) and therefore their earnings per share (even after interest costs) tends to be higher than ungeared companies
    • This does not make the more leveraged company better value.  It actually has a different risk profile to the ungeared company.
These are only a few drawbacks of the P/E ratio - there are plenty of others.  But does this make it useless?  Not at all!

Use the P/E Ratio as part of your analysis of a stock

What I have tried to demonstrate above is that you should never ever buy or sell a stock based on the P/E ratio alone.  It is a tool that you look at in your investment process to determine whether you are paying a good price for a stock after considering the relative merits of the stock: it's earning potential, it's risks, it's leverage and a lot of other factors.

The P/E ratio is something you should keep in the back of your mind.  It is never the first thing you should look at nor is it something that is completely irrelevant.

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  1. I totally agree with your statements, but I just want to make it clear that your warnings apply to ANY single number in isolation. There is no single number that can capture the complexities of the business and financial prospects of a real corporation. Life is just not that simple. A variety of data points must be used, and in many cases, information that is not even easily quantified must be used to describe the situation.

    1. I completely agree with your comments S.B. Whenever I see a commentary on a company which only mentions one or two data points it drives me nuts.

      You also raise another point which I agree with - investors often focus an incredible amount on tangible factors and data points and often forget to think about the intangibles that make an organisation tick (especially when weighing up the risk aspect of an investment)