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Investing Terms 101: What Is The P/E Ratio And How To Understand It?

We often hear investors cite P/E ratios when comparing stocks. Here’s what it means and how to make sense of it.

 

As a new investor, you may come across terms in analysts reports or public filings that you’re not familiar with and still don’t completely understand after looking it up. This article is part of DollarsAndSense’s investor education series, which introduces and explains investment-related terms.

There are more than 700 stocks listed on the Singapore Exchange (SGX), and thousands more on overseas stock markets. Even if you research and invest for a living, companies are so varied such there are just so many different variables.

The Price-Earnings Ratio, or P/E Ratio, is one commonly used (but by no means the only) metric by investors to make sense of stock prices and shortlist stocks that they might be interested to buy.

Today, we will examine the P/E Ratio and find out how we can use it to guide our investment decisions.

Read Also: How Singaporeans Can Start Investing In Overseas Stocks, By Looking At The Companies Around Us

What Is P/E Ratio?

The formula for calculating the P/E ratio is simple enough.

P/E Ratio = Stock Price / Earnings Per Share

Basically, you take the current price the stock is trading at, and divide it by the stock’s Earnings Per Share, which is derived by taking the company’s post-tax profits (earnings) and dividing it by the number of shares (per share). In other words, the P/E ratio tells us how much the market is willing to pay for each dollar of earnings of the company.

Sometimes, companies may be making a loss, and consequently have no earnings – or have negative earnings per share, which poses a challenge when it comes to calculating their P/E. Opinions vary on how to deal with this. Some say there is a negative P/E.

The P/E ratio as it is most commonly used is usually based on the company’s earnings in the past four quarters. In technical terms, this is known as the trailing P/E. Since it is based on the current stock price, the trailing P/E would can be volatile.

Thus, some investors prefer to use a leading P/E or forward P/E. Instead of using historical earnings of the past 12 months, leading P/E is calculated using estimates of projected future earnings (usually for the next 12 months).

What Does The P/E Ratio Tell Us

Whether a P/E is high or low depends on many factors, including the industry and the stage of growth.

Different industries have different norms of what range P/E ratios usually fall into. Technology companies have famously high P/E ratios (for example, Amazon currently has a P/E of more than 200), while companies in more well-established sectors may trade at P/E ratios of around 10 to 25. Using P/E ratios to compare between companies in the same industry and business model would be more useful, versus two wildly different stocks.

If there are two similar companies with P/E ratios of 15 and 25, respectively, one interpretation would be that the stock with a lower P/E is a better buy, since the stock price has not yet risen to the same levels as its peer, which all things being equal, it should. Investors who hunt for value stocks use P/E ratios as one of the factors when they screen for stocks to watch. Conversely, a high P/E/ might signal that the stock is currently overpriced, compared to its actual earnings and growth potential.

P/E ratios are generally co-related with inflation rates, with P/E ratios being lower across the board when inflation is high. This is worth noting when looking at overseas stocks.

Read Also: StockFacts: All The Latest News & Financials You Need To Know Before Investing In SGX Stocks

Limitations Of Relying On The P/E Ratio

It goes without saying that evaluating a stock based on one indicator alone is foolish. While the P/E ratio is useful, it is important to understand its limitations we well.

First, companies that are scaling up rapidly and pump in plenty of money into growing their business tend to have low (or even negative) Earnings Per Share. This makes any analysis of their P/E difficult.

Also, many things can affect a company’s earnings, which does not tell the full picture of a company’s longer-term profitability and growth potential. Earnings can be affected by one-time liquidation of prized assets, or be funded by the company taking on enormous debts that will be due in the near future. Two companies might have similar P/Es, but one might be debt-free while the other might be neck-deep in outstanding liabilities.

There are also ways for companies to deliberately bring down their P/E (and thus make their stock seem more desirable), such as through acquiring other firms that have a significantly lower P/E ratio, and thereby lowering the parent company’s P/E, even though nothing of significance has really changed.

It is also worth remembering that a low P/E does not necessarily mean that the stock is a good value. The stock price might be low because the market realises that the company is in dire financial straits or that prospects for the entire industry is bleak for the foreseeable future. As an investor, know that even if a stock is indeed undervalued, it could take years for the market to recognise its actual value.

Conclusion

The P/E ratio is a common metric that investors and analysts use to evaluate whether a stock is currently overpriced or undervalued, compared to its peers. Now that you understand what it is, and what it is not, you can better make use of that number to shortlist stocks that you might be interested to invest in.

So now that you understand the P/E Ratio better, what is another investing term you want us to cover next? Let us know on the DollarsAndSense Facebook page!