Education Article – Price to Earnings Ratio
Among the most familiar and widely used tools to value shares is the Price-to-Earnings Ratio (P/E).
The formula for calculating the P/E of a company is: Share Price / Earnings Per Share
The idea behind P/E is that we need to evaluate a share price in relation to what it buys in terms of earnings and to help us judge whether a company is fairly valued, overvalued, or undervalued. The scaling of price per share to value per share also makes comparisons possible among different listed shares. For example, an investor pays more per unit of earnings for a share with a P/E of 20 than for another share with a P/E of 12. If the two companies are otherwise closely similar (if they have similar risk, profit margins, and growth prospects, for example), the investor may conclude that the shares of the second company are undervalued (or cheaper) relative to the first.
P/E is a useful investment tool but the determination of the appropriate earnings per share number is easier said than done and in most cases requires detailed analysis of a company’s business outlook and financial history.
To quote Warren Buffett: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
Investors should be careful about the conclusions drawn from the P/E. For example, a company trading on a low P/E is not necessarily cheap and therefore a sound investment. There may be a number of valid reasons for the low P/E such as poor management, uncompetitive products, low returns on shareholders’ equity, low growth expectations for earnings and dividends, highly leveraged balance sheet etc.
The opposite may also be true. A higher P/E company is not necessarily a bad investment as there may be many reasons to justify a high P/E such as a dominant position of a company in its industry with a clear competitive advantage, high and sustainable growth rates in earnings and dividends, consistent high returns on shareholders’ equity, quality of management etc.
For more information on the PE Ratio, please have a read of the following.