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By Pehon | July 29, 2007
Price Earning (P/E) ratio. You’ll find this ratio all over research reports, and its probably the most important ratio of any particular stock, as it seems that it determines the fair value of a company.
P/E ratio of a stock is a measure of the price paid for a share relative to the income or profit earned by a firm per share. But what does it mean to a retail investor like me?
P/E ratio is calculated by the following formula.
P/E ratio = Share price / earning per share (EPS)
An example. If Company X has a stock price of $2, with 400,000,000 shares in the market and a profit from 29-July-06 to 29-July-07 of $20,000,000, the company’s EPS would be $0.05. With that, the P/E ratio would be
P/E ratio = $2/$0.05 = 40 P/E
Thats the low down on how you would calculate the P/E. But what’s the theory and principle behind P/E ratios?
THEORY
Using P/E ratio of a stock, investors can compare a particular stock’s valuation relative the the rest of its competitors and industry average. In general, a relatively high P/E (compared to similiar companies) may mean 1) Investors view the company as higher potential than its competitors or 2) The stock is subject of highly speculative and dangerous bubble.
Before I continue, the P/E ratio is simply just a theory. It doesn’t mean that a low P/E ratio consitutes a “buy”, and a high P/E ratio is a “sell”. There are several factors that come with it, and we will be looking at some of them thru this blog post.
So how do analysts derive a fair value for a particular company, using the forcasted P/E ratio? Well, basically, analysts would look at the average P/E ratios of similiar companies in the same industry, ideally in the same stock exchange and use them for comparison. For example, Starhub’s P/E ratio would be compared to Singtel’s, and China Sport’s would be compared to China Hong Xing’s.
Industry’s and Market’s P/E
You must have heard about a particular market’s P/E and industry’s P/E. It involves the average of stocks’ P/E within the respective catagory. Market P/E used by analysts to predict whether a particular stock exchange’s stocks are over bought and a bubble forming.
Similiarly, an Industry’s P/E would be used by analysts to predict whether a bubble is forming in a industry.
Take for example, a few years back when the Dot Com Bubble burst. Prior to the burst, the industry was averaging out on 30-40 P/E. And the day came when internet companies started getting themselves into financial difficulties, pushing the sky rocketing P/E back down to earth.
“All it takes is a spark to break a bubble”
However, its to be noted that high P/E doesn’t neccessary be bad.
High P/E. Sell?
Its not neccessary the case to keep away from High P/E stocks. For a stock to be priced at high P/E and to have a low risk of a bubble, they must have the financial performance to back the premium that investors pay for.
What happened back when the Dot Com Bubble was forming, internet companies were not producing credible financial performance to support the High P/E they were being priced at. The High P/E was pushed to that level cos of alot of speculative investors who were ridding the wave and hoping for profits that never came. The spark that shook the industry into a sharp correction was when companies started going bankrupt.
“Hence, when you buy High P/E stocks, make sure the company is already making consistant quarterly profit and revenue growth.”
If you noticed, High P/E companies usually involve companies that have large profit growth. Hence its important not to shy away from these companies, as they present a worth it premium for investors.
Low P/E, Buy?
I advise investors to buy stocks that have relatively lower P/E compared to industry average. There is a reason why money is going into the other companies in the industry pushing their P/E higher. The reason is simple. They are companies that are making profit growth quarterly.
“The reason why a company would be priced lower than the industry average is cos the company has no profit growth at all, or is making quarterly loss”
The only situation where I’ll recommend buying Low P/E stocks is when the company is starting to show investors that they are improving their financial performance in the form of quarterly profit and revenue growth.
Conclusion
P/E ratios are a good tool for finding fair values for companies. However, do not shy away from High P/E companies if they have the good financial growth to back it up. A High P/E company or industry with no real profit growth or making annual loss is extremely risky, as all it takes is a spark for the stock to go tumbling down.
Topics: Quick Lesson |
Comments
July 29th, 2007 at 11:41 pm
Hi pehon,
Just to add to what you said, looking at cash conversion and the cash flow statement is also an important aspect of analyzing a company. Revenues and profit are of course good, but an investor should always watch cash as some companies burn cash faster than they generate (some dot.coms as well !). So this is one possible danger sign too.
July 31st, 2007 at 9:47 pm
Good point dude. thanks for adding to my article.