After a broader and comprehensive review in the past weeks of what investment analysis involves, its importance in investment decision-making and some of the investment analysis methods, we want to narrow down our focus this week on one of the most widely used stock market valuation methods: the price earnings ratio (the P/E or PER). It is a measure of share values of a company based on its share price and profitability.
The P/E ratio is a valuation method that adopts a technical analysis of investments as it focuses on the prices, though fundamentals such as earnings are also used.
Definition of the PER
The P/E ratio of a share is a measure of the price paid for a share relative to the annual income or profit earned by the firm per share. Simply put, it measures how expensive a share is. A higher P/E ratio means that investors are paying more for each unit of income. The reciprocal of the P/E ratio is known as the earnings yield. The earnings yield is an estimate of expected return to be earned from holding the shares.
P/E ratio = Price per share / annual earnings per share
For example, if share X is trading at K33 and the earnings per share for the most recent 12 month period is K3, then stock X has a P/E ratio of 33/3 or 11. Put another way, the purchaser of stock X is paying K11 for every Kwacha of earnings. Companies with losses (negative earnings) or no profit have an undefined P/E ratio (denoted by N/A, not applicable). Sometimes, however, a negative P/E ratio may be shown. In the formula above, the price per share (numerator) is the market price of a single share. The earnings per share (denominator) is the net income of the company for the most recent 12 month period divided by the number of shares in issue. In developed markets, most shares trade between a 15-25 P/E ratio. A ratio higher than 25 must have really good expected earnings or the counter risks a drop in its share price. The P/E ratio can also be calculated by dividing the company’s market capitalization by its total annual earnings.
Using P/E ratio to make investment decisions
By comparing price and earnings per share for a company, one can analyze the market’s share valuation of a company and its shares relative to the income the company is actually generating. Investors can use the P/E ratio to compare the value of stocks: if one share has a P/E twice that of another share, all things being equal (especially the earnings growth rate), it is a less attractive investment. The P/E ratio is a relative valuation method that looks into various companies, industries, sectors and time periods. Companies are rarely equal, however, and comparisons between industries, companies, and time periods may be misleading As such care must be taken when comparing P/E ratios for different companies/industries to avoid making wrong conclusions.
Determining Share Prices
Share prices in a publicly traded company are determined by market supply and demand, and thus depend upon the expectations of buyers and sellers. Among these expectations are:
—The company’s future and recent performance, including potential growth;
—Perceived risk, including risk due to high leverage (debt);
—Prospects for companies of this type, the market sector
If earnings move up in line with share prices (or vice versa) the ratio stays the same. But if share prices gain in value and earnings remain the same or go down, the P/E rises.