Sunday, February 17, 2013

P/E Ratios

Hey there,

Today I’m going to be focusing on this part of the key measures

So first of all, I have to say I am not sure what the aspect earnings model is. So if anyone would like to shed some light on that, please please please post a comment or send me an email. Otherwise I’ll spend a bit more time doing some research and trying to find out what it means.

P/E Ratio or price to earnings ratio is quite simple to understand I think. Basically it is the company’s current share price compared to the company’s earnings per share. So in other words it is:

Market Value per Share/Earnings per share (EPS)

Say company XYZ’s current market value is 20 dollars and the earnings per share is 2 dollars the P/E ratio would be 20/2 or 10. The math is very simple but what you make of it is a different story I guess.

Some people look at the P/E ratio as a marker of value and some look at it as a marker of future growth. So a low P/E ratio 0-10 can mean that the company is undervalued or the company’s earnings are thought to be in decline. A P/E ratio of 10-17 is usually considered fair value and a company with a higher P/E ratio say 17-25 can be considered to be overpriced or have a lot of potential for growth.

It is always important to compare company’s P/E ratios within their relevant sectors. For example, mining companies that are still exploring may have a very high P/E ratio and when they find something their P/E ratio might go even higher. Does this mean that the company is overvalued? I’m not sure. But I know it can also mean that the company has found something, is working on extracting it and will eventually (hopefully) earn some money from it. In this case, the high P/E ratio can be normal and is more reflective of the company’s future earning potential.

On the other hand, if we were talking about a bluechip supermarket company, some people might view the P/E ratio as an indicator of its current value. If the earnings per share is 2 dollars and the current market value of the share is 50, that gives you a P/E ratio of 25 which can be considered high. If one day the supermarket is found to be selling chicken infected with salmonella, an overreaction from the market could push the share price down to 20 dollars, bringing the P/E ratio down to 10. Now if the company is unlikely to go bankrupt from this event, and you think that they will eventually go back to normal you can say that the company is currently undervalued and can buy some shares in them.

Another way to look at this P/E ratio is the long term average. Say a company is earning 2 dollars per share and it’s long term average P/E ratio is 15. If it is trading at P/E of 10 ($20) for whatever reason, and you anticipate the prices to rebound to its long term average of 15, it will be a good idea to buy because a P/E of 15 would mean that the market value of the share will be 30 dollars.

I think the most important thing of all is to not judge a stock/company purely based on the P/E ratio. Always remember to look at everything else. Look at the company’s website, etc. So is P/E ratio something that you always look at before buying into a company?

I hope this post has been helpful. Next week, P/B ratio.

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