Price/earnings ratio explained
The price-earnings (PE) ratio 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 PE 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.
How to calculate the PE Ratio
The PE 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.
PE ratio = share price/earnings per share
What does a PE ratio tell us?
- A high PE ratio suggests that investors expect a high level of earnings in the future, and that growth will be strong. The share price has risen faster than earnings, on expectations of an improvement in performance
- A low PE ratio can arise as a share price falls while earnings remain broadly unchanged
The advantage of a PE 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 PE ratio allows an investor to reduce the choice to a smaller number, removing those based on a particular criterion.
For some investors, a high PE ratio might be deemed attractive. A higher PE suggests high expectations for future growth, perhaps because the company is small or is an a rapidly expanding market. For others, a low PE 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 PE may be viewed as having a more reliable record than one where the forward PE is in its twenties.
What is considered a good PE ratio?
Defining a ‘good’ or ‘bad’ PE 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 PE of 15 for a house building company means little unless an investor finds that the average PE for the house building 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 PE relative to the sector may struggle, if it fails to meet forecasts.
PE 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.
Very low vs very high PE ratios
It is arguable that a PE 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 PE 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 PE ratio is not necessarily a warning sign that expectations have become too high. To take a classic example, Amazon trailing PE 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 PE ratio, then it can pay off.
How to use the PE ratio in your trading
The PE 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 PE 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 an investing strategy based purely on the PE ratio, it is perhaps better thought of as a first step along the road to making an investment in a specific company.
