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The price to earnings (PE) ratio is the most commonly used way to value a company’s shares

When fund managers, analysts, the financial press and so on talk about ‘cheap’ and ‘expensive’ stocks, it’s important for anybody thinking about investing to know what that actually means.

It does not mean that because a company’s share price is £100 it is expensive, or that because it’s share price is £2 it is cheap.

In fact, the stock with the £2 share price might possibly be more expensive than the one with the £100 share price. It all comes down to measuring the value a share price puts on the business.

There are a number of ways to measure value and we’ll touch on all the main ones over the next few articles of this series.

For now we’ll start with the most commonly used and most talked about metric – the price-to-earnings (PE) ratio.

The PE ratio is probably the simplest way to measure the value of a stock and can be one of the most effective. It is simply the company’s share price divided by its earnings per share (EPS) figure.

A company’s share price can easily be found with a Google search or on the London Stock Exchange website, while its earnings per share figure – and indeed numbers like the PE ratio and other valuation metrics – can be found via financial information providers including Bloomberg or Refinitiv, or via free-to-use websites such
as Shares’ own website or Sharecast.com.

HOW MANY YEARS TO PAY YOU BACK

A good way to think about the PE ratio is that it tells you how many years the company would take, with profits at current levels, to make enough money to cover the cost of all its shares in issue. A company’s PE, and other valuation metrics including the ones we’ll look at in the next few articles, is often referred to as its ‘multiple’ or ‘rating’.

Remember, a company’s share price isn’t driven by the here and now – it’s about the future outlook, with investors always looking at what they believe is likely to happen to the business in the next 12 months to two years. So that’s why it’s more useful to look at a company’s forecast earnings figure and its forward PE than to rely on historic figures.

For example online fashion retailer ASOS (ASC:AIM), a beneficiary of the shift to online shopping during the coronavirus pandemic, in September 2020 was trading on a 12-month forward PE of 47.9 according to Stockopedia, meaning it would take 47.9 years for the company to make enough money to buy back all its shares at today’s price.

This is considered an expensive stock with a ‘high rating’. Companies with high ratings are usually given such a price tag because the stock market believes their income stream is high quality and/or that they have good growth prospects going forward, with investors in effect paying up for that future growth today.

In comparison, a ‘fair value’ stock may be considered one with a PE of under 20 times forecast earnings, while a cheap stock would be one with a PE of under 12 times. There are variations across stocks and different types of business. A PE in single figures would often suggest there was a serious problem with the business.

CHEAP FOR A REASON

For this reason it is not as simple as saying if one stock is really expensive and one is cheap, you should just go for the cheap one. Not so fast. Often there is a reason the cheap stock is cheap.

In his book Making the Right Investment Decisions, author Michael Cahill gives the example of banks and housebuilders.

Back in 2007 they were trading on very low PEs but trading was still very good, he says, leading to some fund managers to think the shares were cheap.

However the key here, Cahill explains, was that the shares were anticipating a sharp slowdown in the economy, especially in the housing market, and reflecting the high risks in that sector especially for those with a lot of debt. While the stock market doesn’t always get it right, on this occasion the shares accurately predicted the looming problems.

In reality they were anything but the bargain they appeared
to be.

It’s also important to note certain sectors where PE is a less useful measure, like the finance and property sectors, where firms are often better measured by asset values rather than earnings.

For a property company the focus is often on the value of its assets divided by the number of shares in issue. This is called net asset value (NAV).

In addition, it’s pointless to use the PE ratio to value companies where there are currently no earnings, such as start-ups. Also cyclical companies which have fallen into losses, or very low level of earnings which distort the PE, would also be inappropriate. As would companies with large amounts of debt, something not factored in by a PE.

In these instances, enterprise value/sales or EV/earnings before interest, tax, depreciation and amortisation (EBITDA) could be more useful measures. We’ll discuss these in later articles in this series.

You mind find a company has done really well and released a bumper set of results with high levels of profit, but it has a low PE.

This will likely be because the market sees little prospect of further growth, with the company dominating its market and/or reporting good profit margins, but with no defined strategy for generating further growth.

USING THE PE ALONGSIDE OTHER MEASURES

The PE undoubtedly has some limitations but there is value in its simplicity. There is nothing to stop you using the PE as a starting point and then using other metrics to get a more in-depth idea of how a business is being valued by the market. 

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