P/E Ratio (Price-to-Earnings Ratio)
If you want to invest in shares on the stock exchange, it is very useful to look at the P/E ratios (price-to-earnings ratios) of the companies you are interested in.
The P/E ratio of a company tells you how cheap or expensive the current share price of the company is.
You can calculate the P/E ratio of a company with the following formula:
P/E ratio = price per share / annual earnings per share
The higher the P/E ratio of a company, the more expensive its share price.
What does the P/E ratio of a company mean?
The P/E ratio is expressed in years.
It is the number of years it will take for the after-tax earnings of a share, to be equal to the current purchase price of the share (assuming the earnings remain constant, and ignoring the time value of money).
What should I consider when looking at a P/E ratio?
In general, there are three main things I try to keep in mind when I look at the P/E ratio of a company:
- How the expected future earnings of the company differ from its current earnings.
- The earnings of the company must at least beat inflation.
- The higher the risk of the company, the lower the P/E ratio must be.
Current P/E ratio vs. Forward P/E ratio
For the P/E ratio of a company to be meaningful, the expected future earnings of the company should at least be similar to its current earnings.
If there is a good chance that a company’s earnings will dramatically increase or decrease over the next year, it is better to consider the forward P/E ratio of the company:
Forward P/E ratio = price per share / expected earnings per share for next year
In general, the lower the risk of a company, the more meaningful its current P/E ratio will be, because the company’s earnings will be more stable.
Maximum allowable P/E ratio
To start out with your analysis of a company, it is useful to determine a maximum allowable P/E ratio. You can do this by looking at the current rate of inflation.
If the current rate of inflation is 8%, the maximum allowable P/E ratio that will make a company a worthwhile investment can be expressed as:
Maximum allowable P/E ratio = 100% / rate of inflation = 100% / 8% = 12.5
If a company has a P/E ratio that is higher than this value, it means that the returns on your investment is not likely to beat inflation. In other words, you will effectively be making a loss, if you take into consideration the time-value of money.
Higher risk needs lower P/E ratio
The higher the risk of investing in a company, the lower the company’s P/E ratio should be.
A low-risk company that offers consistent returns, consistent dividend pay-outs, good company management and that has a proven track record over a few years, can be a worthwhile investment, even if it has a P/E ratio that is only marginally lower than the maximum allowable P/E ratio.
On the other hand, for a high-risk company to be good investment, where you are less certain of the company’s future performance, the company should have a P/E ratio (or future P/E ratio) that is much lower than the maximum allowable P/E ratio, and thus, offer potential returns that is well above inflation.
This definition is part of the Dictionary of Financial Terms. If you want to receive a notice every time a new definition is published, you can subscribe to Liberta.
