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Price to Earnings Ratio (P/E Ratio)
[Formula: current share price
÷ earnings per share]
P/E Ratio figures can be found on the Direct Broking website under the
Quick Quote "Detailed" view.
The P/E Ratio is an indicator of the underlying value of a company in relation
to the current share price and the reported earnings per share.
A P/E Ratio for a company is most effective when compared against a P/E Ratio
of companies within the same industry. Due to the differing natures of their
respective industries, a
Telecommunications supplier may have different earning potential and
subsequent earnings levels than those of a
Mining company. Therefore, comparing their P/E Ratios may be
misleading.
Companies by industry can be found on the Direct Broking website using the
Market Indices lists.
A P/E Ratio figure can be used to evaluate:
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COST:
the amount than an investor pays per $1 of earnings
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RETURN:
an estimate of how many years it would take for the investor to recoup their
initial investment cost (if company earnings were at a constant level)
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CONFIDENCE: because a P/E Ratio is based partly on
the current share price, it can be an indicator of confidence that other
investors have in the company's ability to grow and earn further capital
EXAMPLE:
| Company "ABC" |
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Company "XYZ" |
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| Telecommunications supplier |
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Telecommunications supplier |
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Current share price |
= $0.50 |
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Current share price |
= $50.00 |
| Earnings per share |
= $0.025 |
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Earnings per share |
= $5.00 |
| P/E Ratio |
= $0.50 ÷ $0.025 |
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P/E Ratio |
= $50 ÷ $5 |
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= 20 |
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= 10 |
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COST: Investors who pay $0.50
for 1 share in ABC
are paying 20x the amount of earnings per
share ($0.025). In other words, they are
paying $20 for every $1 of earnings. |
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COST: Investors who pay $50.00
for 1 share in ABC
are paying 10x the amount of earnings per
share ($5.00). In other words, they are
paying $10 for every $1 of earnings. |
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RETURN: It would take 20 years
of the company
making consistent earnings for an investor to
recoup their initial investment costs if they
purchased ABC at $0.50 per share. |
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RETURN: It would take 10 years
of the company
making consistent earnings for an investor to
recoup their initial investment costs if they
purchased XYZ at $50.00 per share. |
Comparing ABC to XYZ
At first glance, shares in XYZ ($50.00 each) appear "more expensive" than
shares in ABC ($0.50) and this may prompt some investors to purchase shares in
ABC.
However...
COST:
When you compare the P/E Ratio for these two companies you can see that an
investment in XYZ gives an investor more "value" for their shares because they
are only paying $10 for every $1 of earnings, as opposed to $20 for every $1
with ABC.
RETURN:
XYZ also provides a (potential) shorter timeframe for an investor to recoup
their investment costs - 10 years as opposed to 20.
CONFIDENCE:
Unlike the mathematical nature of "cost" and "return", the level of perceived
"confidence" in a company is drawn from unpredictable human emotion,
particularly fear and greed. A high P/E Ratio could indicate that the
company is overvalued or that it is successful and has the balance sheet to
prove it. Similarly, a low P/E Ratio could indicate that the company is
undervalued or that it is not able to maintain a profitable level of growth.
No P/E Ratio figure?!
As previously discussed, a company within one industry may have different
earning potentials and levels than a company in another industry.
A company may have erratic earnings levels or no earnings at all, therefore a
P/E Ratio figure may not be displayed on the Direct Broking website.
The absence of a P/E Ratio figure does not mean that the company has "gone
bust" or is a "bad buy"; it simply means that the company may be exploring new
ways to raise capital and the results are yet to be proven and/or published. A
good example is that of a mining company during a period of exploration for oil
reserves - no oil means no earnings!
Summary
After using a P/E Ratio figure to take levels of "cost" and "return" into
account, an investor must then decide how they are going to interpret the P/E
Ratio figure as a measure of confidence, as the PE Ratio is partly based on the
current share price.
Do you see genuine potential where others simply see the flavour of the month?
Further study
Analysis of P/E Ratios can be a beneficial part of an investor's research and
should be used in conjunction with further research and analysis.
Direct Broking has created a series of educational articles about the following
terms:
Dividend
Yields
Net Tangible Assets per Share
Earnings
per Share
<< Part 5. Earnings per Share
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