Understanding Price/Earnings Ratios

Perhaps one of the most common measures used in determining whether a share is good value is the price/earnings ratio, or P/E ratio as it is most commonly known. This represents the share price divided by the after-tax earnings per share (EPS). EPS is in turn calculated by dividing a company’s 12-month net profit by the number of shares in issue.

There are many other gauges that could be used, and you will find advisers who favour, for example, the Price/Book ratio, but the Price/Earnings ratio is the most popular, and is quite often provided when only one statistic is available, and serves as an instant reading on the value of a share. It is computed, using per share data, as:

CURRENT PRICE / ANNUAL EARNINGS = P/E RATIO

 

What Purpose does it Serve?

The Price/Earnings ratio provides a quick comparison for determining whether a share is ‘cheap’ or ‘expensive’ as it measures how long it would take, in years, for the company to earn sufficient money to justify its current valuation (assuming profits remain the same). The Price/Earnings is also used to calculate how much you are being asked to pay for future earnings. Shares with low Price/Earnings are ‘cheaper’ than shares with high Price/Earnings ratios. If both companies operate in the same industry sector and have comparable earnings, but different Price/Earnings ratios, one can conclude that the share with the lower Price/Earnings ratio is cheaper. This doesn’t mean it is a better buy as the market may be discounting a lower projected growth rate, or some other problem. Of course, it might simply be cheaper. The Price-Earnings is just one good indicator to check when making comparisons between shares.

Types of Price/Earnings Ratios

The first thing you should do when you notice that a share has a ‘Price/Earnings ratio of 21’ is to find out what kind of P/E ratio this is as there are several different Price Price/Earnings ratios. This usually depends on the kind of earnings figure that is being used.

Trailing Price Earnings Ratio: The earnings refer to the most recently reported quarter, as well as the previous three reported quarters. The abbreviation TTM is sometimes used to indicate Trailing Twelve Months. However, what this really means is that it is trailing four quarters of reported numbers.

Forward Price Earnings Ratio: The earnings number is the total of estimates for the current unreported quarter and estimates for the following three quarters.

The other computation which affects earnings is one-off charges. These extraordinary expenses are classified as non-recurring, and are listed as a separate line item on financial reports. These could be costs associated with a closure of a company’s division or merger, or some other one-time event. Usually most analysts exclude these charges from earnings calculations. (In fact, it is well known that Wall Street routinely disregards one-off charges altogether even though the expense is very much real!) If you are computing your own Price/Earnings computations from annual reports or from screening databases, you should probably make your calculations using the earnings line which excludes extraordinary charges.

Comparing Price/Earnings Ratios

The price is the share price, and the earnings may be the actual historical earnings, but can also involve future projections of earnings. That is why sometimes P/E ratios are considered confusing.

Even when ‘actual’ earnings are used, often based on the previous quarters’ figures, there is the matter of interpretation – for instance, it would not be unknown for figures to be made to look better by creative accounting than they might otherwise be to encourage investors, or even to assist in the bonus payments of senior staff. But the declared earnings are all we have in terms of proven performance, so that is the gauge that is used.

The earnings can also be based on future projections, and this is where they are more open to creative manipulation. This can be called the “forward P/E” ratio. Fortunately, although earnings may be suspect there is little done to the share price when calculating Price/Earnings ratios. This is almost invariably the current share price, and not based on projections or historic figures.

Having thus cast some caution over basing too much reliance on P/E ratios, it must be said that they are usually used for comparison purposes between companies, so any creativity is probably done to a similar extent between competitors and the comparison is largely valid. If a company has a low P/E it usually suggests that the stock price is undervalued, and this might indicate a long position would be profitable.

For example let’s assume Company XYZ made GBP2.4 million profit in 2009, or EPS of 2.3p, and started the year 2010 at 16p for a historic Price/Earnings ratio of just about 7. Profits are expected to continue booming, however an industry shift catches the company by surprise and two profit warnings ensue which push the share price to 6p – which now represents a Price/Earnings ratio of 7.5 for this year and 4 for next year, if analyst estimates are to be trusted. Of course this is a big ‘if’ and as investors we have to focus on value – this may be an acquisition, or a change in management or even a restructuring plan. The problem here is that companies that are trading on a low valuation are usually cheap for valid reasons – badly run, lacking profits or strategically weak and profits are not growing as a result.

Analysing the Price/Earnings Ratio

The next question is how you know what the Price/Earnings ratio should be, so that you can tell if it is low or high. There is no one answer to this, and there is no perfect P/E ratio. What you can do is compare it to other similar companies, from the same market sector for example, to see how the market is pricing the company relative to industry peers. The sector’s average P/E will vary depending where the industry is in its business cycle, and comparing like with like gives you a good indication of a company’s health.

As a guide, a rough average P/E for most American stocks would be 15. In practice the Price/Earnings ratio is best used with other indicators and not as a standalone tool. The P/E ratio is a measure of company’s earnings, so it also varies depending whether the company is on a growth path or long established and stable. If a company is on a recognizable growth phase, it usually trades at a much higher P/E ratio in recognition of the increased earnings and valuation to come. Equally, a low Price/Earnings ratio can become a high one if a company’s profits collapse.

Beware Over-Hyped Stocks

Take GWP (Gw Pharmaceuticals) in 2003. Gw Pharmaceuticals was hyped by everyone until approvals took longer than anticipated and earnings were much slower than anticipated.

RNVO seems to fit in the same category. No one can tell you how much profit RNVO are likely to make next year or the year after that because there are too many unknowns, so how can anyone know the value of the company? They might even have a product that never makes a profit – we just don’t know. In the meantime its trading at twice the book value (that’s the fair value that the company itself put on it). I’ll be ready to short it on a price cross over on the 40 ema. Others might short it from a 30 m/a or a 50 m/a but be sure there are many like myself waiting for it to bubble higher and then start shorting at the first announcement of the slightest hint of bad news. Check out BLNX to see what I mean.

To look at it from another angle of what its recent price rally means. There are 90m shares in issue. That means at today’s price and a highly rated 20x Earnings Per Share the company would need to be making over £2m profit or 2.3p per share to justify its 46p per share. How long will it be before they make £2m profit and what possible hints of bad news might there be before they get there. In the case of GWP it took a further seven years to reach £2m. That’s the risks you are up against. There is a risk that it might already be overvalued.

Observations: Price/Earnings Ratios

Although it is only one measure that you should use, a low P/E ratio is a good way to start looking for value, and for stocks with potential. However, investors will often pay high multiples if they think a company’s profits stream has especially good visibility or is growing particularly quickly. Very high Price/Earnings ratios can represent a danger. Just a little setback to market expectations can cause the company’s share price to crash. In contrast, companies with low Price/Earnings ratios are relatively safe, although often unexciting. Utilities, for instance commonly trade on low PERs.

Start-up companies in sectors like technology, oil exploration or biotech, where revenues are typically low and initial investment heavy may even trade with a negative Price/Earnings ratio (this simply means that they are operating at a loss). In such cases investors have to balance whether the company’s business model will be viable and look at future earnings potential.

Recovery shares commonly enjoy high Price/Earnings ratios at the bottom of their cycle when a substantial recovery is expected. At the top of the cycle, their Price/Earnings ratios could then fall to below-average levels. Looking at profitability and EPS data at the peaks and troughs of cycles can assist investors judge the future direction in stock prices.

Having said that, because of so many variables and all the variations in P/Es, caution has to be exercised when comparing Price/Earnings ratios (PERs) of stocks operating in different sectors and a negative Price/Earnings ratio should not necessarily put you off as long as the company has a valid business model.

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