Investment talk is exciting. At least from my point of view. So if investing doesn’t talk doesn’t excite you worry not as I surely have enough excitement for the both of us. When investing in shares or stocks you will hear a lot of talk about ratios or multiples and we have an article that briefly explains the meaning of some of these. When talking to new investors I often get asked which ratios are the most important. While all ratios matter I always tell people the price/earnings ratio or PE is the most important for investors. Read on if you want to know why and what it means.
I have to preface the discussion on the P/E ratio with a discussion about being an investor in general and stock market investing in particular. Firstly we need to understand that the investor is a very simple being. The investor puts up the money and expects a return, simple as that. Now when we look at stock market investing in particular we understand the investor realises this return in one of two ways, capital gain or dividend payments. On the surface the two seem very different, capital gain is the increase in value of the investment while dividends are profit distributions made by the company to investors. However, the two are actually closely related. With capital gain, the value of an asset is the present value of the sum of its expected future cash flows. To put that in English the value of a share is the approximation of the value we expect to receive in future. Dividends are not guaranteed and are also arbitrary so we look at the earnings or profit the company makes to guide us on a value based on what we expect in the future. With dividends remember they are paid out of past and current profits (earnings) so you can see there is a link between capital gain and dividend through earnings. The price is of course very important to the investor because it is what the investor pays to acquire the shares.
So what’s this P/E ratio all about? Well, the price-earnings ratio is a measure of the price of a share compared to the earnings generated by the company attributable to that share. It is calculated with e following formula;
P/E = market price per share/earnings per share
You can see that once you understand this the name makes sense. Earnings per share are found at the bottom of the Income statement. It is simply the company profit or earnings divided by the number of shares to find how much earnings are attributable to each share. The price in this case is the market price of the shares on the stock exchange.
P/E calculation examples
To get our heads around the idea of the P/E ratio let’s look at some practical calculation examples. These are based on the last full-year financial results published by each company and the closing price on the 14 of September 2021. As you will see there is wild variation in the P/E ratios.
Now that we know the P/E ratio let’s take some time to understand it. In simple terms, the P/E ratio is a measure of how many dollars we have to pay in price to “earn” one dollar through owning company shares. So when P/E is 15 it simply means one must pay $15 to earn $1 through the company. Please remember that earnings are profits attributable to the share but are distinct from profit distributed to the shareholder (dividends). Remember what we said earlier about the investor being a simple creature? It’s a matter of dollars in(vested) versus dollars out (profit).
Some things to note
So with that understanding of the P/E ratio, you may be in a rush to say well $100 is too much to pay for $1 of earnings and while in many cases you would be right I would ask you “compared to what”? This is a very important issue when it comes to P/E ratios, while they make great standalone indicators it is not the best idea to look at them in isolation. While historical examples from people such as the renowned author of The Intelligent Investor, Benjamin Graham, suggest a good P/E range is between 15 and 25 you will find that this may not hold in practice. It may be best to compare P/E ratios with similar industry companies and/or industry averages.
Just a quick note on a ratio called the earnings yield. It is the converse of the P/E ratio expressed as a percentage. It gives the earnings per share as a percentage of the price. This is useful if you’re trying to compare the earnings per share to a percentage rate of return or alternative. Perhaps you want to simply compare to an economic indicator such as inflation. If you have your P/E ratio all you have to do is invert it (divide 1 by it) and express the resulting ratio as a percentage.
Now that you are armed with an understanding of the P/E ratio feel free to include it but not exclusively in your analysis of companies. Remember, just because it’s the most important ratio for an investor in my opinion it doesn’t make it the only important ratio.