What is Price-Earnings Ratio?
When we look at investment pages or books, authors almost always look at the Price-Earnings Ratio (PER) as basis of their comparisons and decide whether to buy or sell a stock. So, what is this magical PER that they are talking about?
The price-to-earnings ratio (often abbreviated as PER or P/E ratio) is the ratio for valuing a company. It measures the current share price of a stock, relative to its earnings per-share (EPS). PER is also sometimes known as the price multiple or the earnings multiple.
Investors and analysts use PER to determine the relative value of a company’s shares in an apples-to-apples comparison. It can also be used to compare a company against its own historical record or to compare aggregate markets against one another or over time.
Simply put, PER shows the current price you must pay per unit of current earnings of a company. A higher PER may hence signal that a company is over-valued, meaning the company is not worth its current stock price and thus not optimal to purchase now. Alternatively, a higher PER may also signal high expectations of a company, thus investors are buying the shares now with hopes of the company performing better in the future, and hence its high share price.
Using Price-Earnings Ratio
From above, we can see that merely looking at the PER of a company tells you little about it. If a company has a PER of 10x, is the stock price of the company a bargain? Likewise, if its PER is instead 50x, is the stock price expensive? Instead, PER should be used as a comparison against a company’s historical PER, or the PER of a competitor from the same industry. Since PER standardizes companies of differing stock prices and earnings, we can then compare and see how a company’s earnings fared over time, and how does it compare with its competitors.
PER is commonly used because it provides a simplified process of determining whether the stock price of a company is fair i.e., not overvalued. Thus, investors typically look out for companies with low PER, as this signals that the company is undervalued (stock price trading lower relative to its actual value). Such companies are known as value stocks and this presents a bargain for investors to enter at a low price and make a profit when its price eventually corrects to its actual price.
Let’s look at an example. Two stocks in the same industry, Stock A is trading at $40 and Stock B at $30. If the industry average PER is 20, and Stock A has a PER of 20 and Stock B has a PER of 40, what can we make sense of the numbers? This signals to us that while Stock A has a higher absolute price, it is cheaper than Stock B because you pay less for every dollar of current earnings. However, you can also imply that Stock B has a higher PER than its competitor and the industry, and this might mean that investors have high expectations of future earnings of the stock.
PER is a great and simple tool to help us make sense of a company’s relative position. Without it, the stock price of a company may seem like just an arbitrary number and we might not know how to proceed. Having said that, PER is not an all-encompassing magical formula to stock picking. From the above example, we can see that PER provides us with better clarity into the meaning of the numbers, however we will require more information before we make the final decision whether to buy a stock or not. Investors will still have to do further due diligence in analysing a company’s fundamentals before arriving to a sound decision.
– Bronson (@bbbrnsn), Financial Services Consultant