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P is for PE Ratio – The Elite Investor Club’s A – Z Guide of Investing

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To join the Elite Investor Club, go to – http://www.eliteinvestorclub.com/ To attend our yearly flagship event on Saturday the 7th November, head on over to – http://www.eliteinvestorsummit.co.uk/ We’ve reached the letter P in the A-Z of investing, and it’s an important measure of the value of a share that surprisingly few people understand. P is for Price-Earnings Ratio. Andrew Craig was presenting at a recent Elite Investor Club meeting and he asked for a show of hands on who understood what a Price Earnings Ratio was . I felt a bit deflated when only about ten per cent of the hands went up, because this is one of the most basic and important measures of a share’s price. So let’s get straight into the definition. What we’re calculating is the total earnings of the company divided by the number of shares in circulation. Broadly speaking, the lower the price earnings or P E ratio, the better value the share is. It effectively tells us the number of years its going to take for this share to pay us our capital back if we buy it at this price. So let’s look at a company with a share price of £28 and earnings of £1.43 per share. We divide the share price by the earnings per share and get a figure of 19.58. In other words, at current earnings levels we’d need to hold this share for two decades to get our money back. Whether that represents fair value, a bargain or a rip-off is of course dependent on lots of other factors. P/E ratios vary by sector, with technology companies often attracting the highest ratios because investors believe there are blockbuster earnings around the corner. If you take the business model of a software company as an example. Once the software is built the marginal cost of each extra copy is close to zero. So, provided the market likes and buys the software, their earnings and profits can go ballistic. People look back to Microsoft, Google and Facebook to convince themselves that Uber, Twitter and AirBNB will enjoy similar growth. Last time I checked Twitter, you’d need to own it for ninety eight years to get your money back. That strikes me as being on the bonkers side of optimistic. A low PE ratio may mean you’ve found a bargain, or a company that is suddenly out-performing against its previous results. You can also apply a price earnings ratio to a whole market like the FTSE one hundred. Because PE ratios can vary widely from one type of company to another, one of the best ways of using them is to compare companies within the same sector. If a sector averages a PE of twenty and you find a company on a PE of twelve, you may have found a bargain. However, there are some traps awaiting the unwary. If a company takes on more debt, it can have the effect of lowering the PE ratio and making it look more attractive than a competitor with less debt. If business is good it could end up outperforming and being a great buy. But, in a downturn the cost of servicing that debt could cause significantly reduced earnings so you’d have been better off buying the company with the higher PE. While the share price is set by the market and is public domain information, the way in which earnings are calculated and presented is open to manipulation. If based on past earnings, there’s no guarantee those earnings will be maintained going forward. If based on future earnings, how accurate might the estimates prove to be? And of course, if a company has no earnings, it can’t have a price earnings ratio! For all these reasons, the PE ratio should be seen as a starting point in analysing a company’s performance. A relatively blunt instrument and one that needs to be accompanied by some other homework before you click the Buy Now button.