Last Updated on 9 July 2021 by Dan
Hello everyone! Today we return to looking at some of the more technical aspects of investment by looking at the Price/Earnings Ratio, more commonly known the P/E ratio.
It’s understanding some of the metrics like this which can help critically assess if something is a good investment or not. In the case of a P/E ratio, it can help be a building block to understanding if an equity investment represents good value or not.
What is the P/E Ratio?
The price to earnings ratio represents the gap between
The present price of the equity, also known as the share price.
and the present amounts of earnings per share of the company. Earnings in this case is the profit made, so is after any expenses and tax have been paid.
This is simply shown as a proportional ratio between the two. Let’s use an illustrative example:
A company has one share, which trades on the market for £100. It’s earnings for the year are £100. Therefore, it’s P/E ratio is 1.
A company has one share, which trades on the market for £1000. It’s earnings for the year are £100. Therefore it’s P/E ratio is 10.
What does the P/E ratio mean?
We can use the P/E ratio to help try and assess the future expectations of investors about an equity.
Remember that the price of an equity is based on two things – the amount of money that the company is presently generating, and the amount of money that we expect the company to generate in the future.
Let’s take that second example, where we have a P/E ratio of 10. What’s that’s telling us is that investors see the equity as worth paying ten times the value of the present earnings of the business. There’s therefore an expectation that the company will continue to grow over time.
What does this mean?
The higher the P/E, the higher the companies growth rate needs to be in order to justify it’s valuation.
In the example where the P/E value is 1, the market is saying they thing the equity is essentially price absolutely fairly. They expect the company to stay exactly where it is, and neither grow nor shrink.
Why is the P/E ratio useful?
The P/E ratio is helpful because it can give us an example about the relative valuations of companies. If you have two companies that have very similar business models, but very different P/E ratios, it can be worth looking at why investors seem to favour one company more than another. You might reach one of two conclusions;
- There’s another “x-factor” that means one of the companies is simply much more attractive as an investment prospect.
- The low P/E company is undervalued, and the market has not identified that this company has good prospects.
Looking for undervalued equity others have missed is the principle of value investing, the technique used by Warren Buffet to seek out good opportunities. It’s not as simple (by a long way!) as just looking at the P/E, but it’s a good starting point.
Why is the P/E Ratio topical?
A price earnings ratio is one of many factors that an investment analyst will consider, but an exceptionally high P/E ratio will usually act as a warning flag.
Yet looking at what has actually happened in the market, some of the best performing investments you could have had over the last couple of years have staggeringly high P/E ratios. It’s been particularly prevalent in the technology sector – Tesla’s P/E ratio is over 1,000 at time of writing for example.
This opens up a lot of analyst debate about if this is a good investment or represents good value. The story of Tesla is a particularly appealing one for example – you can like what the company is trying to achieve and feel it makes sense as a business. However if it represents good value is an entirely different thing, and what you see from the P/E ratio is that there are huge expectations to be reached if the price is to be justified.
Improving the P/E ratio with the PEG ratio
When you just look at the P/E ratio in isolation and particularly when you’re faced with a high P/E, the next question that then comes to mind is if the underlying growth rate is justified.
The PEG ratio doesn’t answer this entirely, but it divides the P/E by the annual percentage growth that has been seen historically, which brings in some factoring for growth.
It’s not perfect either because it uses a historical growth number which may not be representative of the future, but it can help put the relative value of a company into some perspective.
A final note here – whilst P/E is a great starting point for looking at equity, it’s definitely not something to buy and sell on in isolation! It’s a good tool to consider along with everything else.
If you’re enjoying our articles on stock metrics, we’ve also written about what Beta means.
Still unsure about P/E ratios? Just pop a question in the comments box below!