Price Earnings Ratio or Price to Earnings Ratio

Buy when the PER is low - Sell when it's high!

What is the price earnings ratio (P/E)? It is the current price divided by the earnings per share. It is one of the most commonly used financial measures.

It is quite often incorrectly used as a measure of stock value. I say incorrectly because the intrinsic value of a stock is calculated using the company's economic fundamentals, not its price. The price to earnings ratio is based on the company's price.

P/E Variations

The ratio commonly varies from a low value of 5 to a high value of 25, but some companies may have P/E’s values that lie outside of this range.

Growth stocks tend to have larger P/Es as there is an expectation that their earnings will increase over time.

A P/E of 15 (which is about the average in Australia in normal market conditions) means that the price is 15 times annual earnings. That is, 15 years of earnings would be needed to cover the price paid.

Using the P/E

How do I use the price earnings ratio? I like to consider a buy when the P/E of a company is close to the lower end of its annual range.

It is more likely at that point that the price is approaching, or equals, or is below its intrinsic. However, as the P/E does not measure value, it is guess work unless you can calculate the stock fair value.

Factors Affecting the Price Earnings Ratio

Of course, there is usually a reason why a company’s P/E ratio is in this depressed condition. It may be that the whole market has suffered a downturn because of a global recession, or concern of one occurring.

In this case, the depressed P/E may have nothing to do with the individual performance of the company, and as a result it may represent excellent buying.

On the other hand the depressed value may be associated with some factor that the market has decided will affect the future earnings of the company in question.

This a good reason to do some reading about the company of interest. Annual and interim reports and market announcements about the company are a good start.

Some fairly recent factors that have had a severe impact on some company P/Es have included:

  • increasing fuel prices – airline and transport companies
  • increasing interest rates – property developers
  • worsening drought – grain and stock transporters and equipment suppliers
  • government intervention in managed investment schemes – forestry and horticultural companies
  • aggressive purchase pricing by major toy retailers - toy suppliers
  • tight labor market – manufacturers like 4X4 accessories suppliers.
These are some of the reasons that have had a significant effect, and in a few cases a continuing effect, on the P/E of some companies in the past year or so.

This has presented good buying opportunities when other characteristics of the companies in question were favorable.

None of the above reasons have been terminal for the companies concerned. Short-term hiccups will continue to happen in the future for well-managed companies with a history of excellent performance.

My online broker's site allows me to compare the current P/E of any company to the P/E of the sector in which it operates. That is, with similar companies as well as with the current P/E of the market as a whole.

The price earnings ratio equals the price of the share divided by earnings per share (eps). So ...

Price of the share = P/E ratio x Earnings per share.

All shares exhibit a range of P/Es during any one year. A lot of the variation in the P/E ratio of shares is due to market ‘noise’ and has little to do with the value of a stock.

To Conclude

Buying a share when its P/E is low will ensure that, as the P/E rises (assuming it will) and as the eps grows, the share price will increase over time as per the formula above.

This is why I buy shares that have good eps growth and have their current price earnings ratio at the low end of their annual range.

But more importantly, I require a high return on equity and low debt.

Return from Price Earnings Ratio to Financial Ratios

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