Before choosing a share or block of shares for investment, investors study the charts and reports of companies, but at the same time they miss one important indicator or coefficient – P / E (Price / Earnings)… Let’s try to figure out what this indicator is and how to use it for our own good.
What is P / E?
P / E ratio – This is a multiplier that is used to assess the undervaluation or overvaluation of a company for an investor, and shows the primary investment attractiveness of a particular issuer. Based on the P / E calculation, preliminary conclusions can be drawn about how quickly the investment will pay off when investing in the selected asset.
How is P / E calculated?
P (Price) Is the capitalization of a company or, in other words, the company’s exchange value. Capitalization is calculated by multiplying the price of one share of the company by the number of all its shares in circulation.
Example: Company X has issued 1 million shares, the current price of one share on the exchange is $ 2. This means that the capitalization of company “X” is 2 million.
E (Earnings) Is the company’s net profit for the reporting period. As a rule, data for the last calendar year are used for the calculation. Also, in some cases, they use the projected profit that the company will receive in the future, or rolling profit. It should be borne in mind that sometimes the indicator is overestimated to increase the attractiveness of the company, but in fact the profit may decrease. Simply put, P / E essentially tells us how long it takes for our investment to pay off.
The lower the value of the indicator, the faster the return on investment in the company.
However, not everything is as simple as it seems at first glance. A low P / E indicates that the company is undervalued and its stock will move towards fair value, which is an investor’s long-term return. At the same time, a low value of the indicator may indicate a negative background or serious problems for the company.
An overestimated P / E multiplier (above the market average) indicates that the company is overvalued, and it is likely that investments in it will not pay off in the medium and long term.
3 ways to calculate the P / E ratio
There are three ways to calculate P / E:
- Annual (regular) – the calculation is made for the previous calendar year.
- Sliding – the calculation is made for the previous four quarters, regardless of the quarter in which the calculation is made.
- Forward Is the estimated or predicted ratio. The calculation is made at the beginning of the fourth quarter for the future.
An example of calculating the P / E multiplier
Annual P / E: New Year 2021 calculated P / E based on earnings and share prices for the previous year, 2020.
Sliding P / E: at the end of the first quarter of 2021, the P / E is formed, which is calculated using the last three quarters of 2020 and the first quarter of 2021.
Forward P / E: P / E forecast is made early in Q4 2021. It is biased to use indicators for the fourth quarter of last year due to changes in market conditions. Based on preliminary forecasts and reports, the multiplier is calculated for the next quarter. The calculation will be conditional, but will allow you to see the picture of the company’s development in the future and make a forecast.
How to use the P / E ratio?
To understand the ROI of a particular company, just knowing its P / E is not enough. It is also necessary to compare it with other coefficients, namely:
- Market average P / E ratio.
- The average value of the indicator in the industry of interest (for example, medicine).
- P / E of competing or similar companies.
- P / E of the company for the previous reporting periods.
Due to the development of computer technology and the Internet, the investor no longer needed to independently calculate the P / E ratio. On popular resources about stocks and the stock market, this indicator has already been calculated and is available for analysis and comparison.
In the screener, you can specify the period for calculating the P / E, which the investor considers suitable (for example, up to 5 years), and analyze the data obtained.
Pros and cons of P / E ratio
- Helps to search and find companies with positive investment potential that are undervalued in the market and, possibly, unknown to a wide range of investors.
- Reduces the time required to select stocks in the selected market segment.
- Simplifies the assessment of the attractiveness of a company: you can easily weed out companies with a large or, conversely, with a short payback period.
- Simplifies the forecast of the stock price movement: an undervalued company has more upside potential.
If the industry average P / E is 15, and your chosen company is 10, then the company has growth headroom. Conversely, if the industry average P / E is 15, and the company has a P / E of 25, then the probability of growth is reduced.
- The P / E ratio cannot be used to analyze unprofitable companies – for these purposes there is a P / S (price / sales ratio) P / E ratio analyzes only one parameter – the ratio of the asset’s fair price to the market price. At the same time, there are other parameters that affect the company’s growth (dividends, market or sector state). It is impossible to compare companies in terms of P / E from non-adjacent industries (for example, it is incorrect to compare companies in P / E from biotechnology and heavy industries).
- It is also incorrect to compare companies at different stages of development. For young companies, capital expenditures take a large chunk of profits and the result is a high P / E ratio. In an established company, the profit may be lower, but the costs are insignificant, and as a result, the P / E will turn out to be less.
- The investor already has to decide which company to choose for investment: a rapidly growing company with high P / E or a developed company with little growth potential, but with a low P / E ratio.
For the American market, the normal P / E is considered to be 15-20. The calculation of the P / E ratio is considered conditional, since the profit and market value are constantly changing both positively and negatively.
It is incorrect to consider only the P / E ratio for stock selection, but it plays an important role in this choice. A complete, correct selection of stocks requires an assessment of many other parameters.
It should also be borne in mind that the P / E ratio differs not only by sector of the company, but also by country. The American market has a more conservative approach to investing, so the market average P / E will be high. Here, investors are ready to wait 15-20 years for the investment to pay off.
In the selection of shares, not only the P / E ratio is used, an important criterion for selection is: dividend yield, trading volumes per trading session, analyst recommendations, insider trading and capitalization. In the following articles, we will analyze these indicators in more detail.