One of the most important questions for anyone thinking of buying a share is: Is this stock cheap or expensive?
Get the answer to that question right, and you’re well on your way to picking winning stocks and avoiding the duds.
And there’s one single, easy-to-calculate number that promises to provide the answer.
If you ever read any share tips in the financial press, it’s a number you’ve almost certainly come across.
It’s called the price/earnings ratio, or p/e ratio or short.
The p/e ratio is one of investing’s magic numbers. Others drift in and out of fashion, but this one has stayed the course over decades.
So how does it work?
The price you pay boils down to how much money you expect to make
To understand a p/e ratio, you have to grasp something which is fundamental to every investment decision you’ll make.
The price you are willing to pay for any investment boils down to how much money you expect to be able to make from it in the future.
Say you decide to buy a house to rent out. If you’re a serious property investor, the price you are prepared to pay will depend on how much future rental income you think you’ll be able to get from it.
Clearly this is a subjective judgement. One investor might be more optimistic than most about the level of rent he’ll be able to get, so he’d be willing to pay more. Another investor might be looking for a higher return on her money than the average landlord, so she’d be willing to pay less.
But the point is, the price you pay today is depends on what you think the future rental income will be.
Similarly, a stock is only worth the future profits (or earnings) a shareholder expects to be able to get from it.
From a p/e point of view, it doesn’t matter whether those profits are returned in the form of dividends, or if they are reinvested in the business and therefore boost its share price (in theory). Either way you’ll make money.
It’s the fact the firm is making – and growing – its profits that matters.
How the p/e ratio is calculated
So let’s say you are offered the chance to buy a share for £5.
You also know that last year, the firm in question generated profits of 50p per share. This is known as the earnings per share (the annual net profits divided by the number of shares in issue).
This means, obviously enough, that investors are currently willing to pay £5 for every 50p of earnings (profits) the company makes.
The p/e ratio is simply the price of the share, divided by earnings per share. In this example, it’s £5 divided by 50 = 10.
Put another way, if earnings per share stay at 50p a year for the foreseeable future, it will take ten years (ignoring inflation) to repay your original investment of £5.
In this case, we’ve used the past year’s earnings figure. This is known as the ‘trailing’ p/e.
You could instead use an estimate of the company’s earnings for next year, which gives you a ‘forward’ p/e. The risk here is that while a ‘trailing’ p/e is based on actual earnings, the ‘forward’ p/e is based on an estimate, which may be wrong.
What level indicates good value?
A share with a p/e of five might look a lot cheaper than one with a p/e of ten. After all, assuming current earnings stay the same, the first will repay your money in just five years, compared to ten for the second.
However, the first share might trade on a p/e of five because its earnings are expected to drop next year. As a result, the market is willing to pay less for its earnings, because it doesn’t expect those earnings to be maintained.
For example, drug giant AstraZeneca currently trades on a p/e ratio of around six to seven. That’s because the market is concerned that it will have problems sustaining future earnings because a large number of its key drugs are about to lose their patent protection.
Similarly, a company on a p/e of 20 might be trading at that level because the market expects its earnings to grow very rapidly.
Taking another example of one of the few FTSE 100 tech stocks, chipmaker ARM Holdings trades on a p/e of above 40. The market has been willing to pay handsomely for its earnings because of its exposure to the fast-growing smartphone business.
Similarly, some sectors generally see faster growth than others. The FTSE 100 overall trades on an average p/e of just under 13. But that doesn’t mean that anything above this is expensive, and anything below is cheap.
Tech stocks will usually be rated higher than utility stocks, for example. That’s because earnings for successful tech stocks usually grow rapidly, whereas utility stock profits are usually quite stable, but slow-growing.
In short, you can’t use the p/e ratio alone to decide on which stock to buy. However, if a stock looks unusually cheap compared to others in its sector, it may signal a buying opportunity that merits further investigation.
We’ll look at how to use the p/e ratio – and its strengths and weaknesses – in more depth next time.
Meanwhile, a good exercise is to go and look at the MoneyWeek FTSE share performance table. Click on the P/E column to list FTSE 100 stocks by p/e ratio. You can see that there is a very wide range of p/e numbers.
Remember that the p/e figure ultimately represents the amount investors are willing to pay for a given level of earnings. So to an extent, the p/e reflects how confident investors are that a company can grow or maintain its earnings at a given level.
Look at the stocks with especially low p/e ratios, and those with particularly high p/es. Have a think about why those numbers are so low or so high. And are there any where the p/e doesn’t seem like a very helpful measure to use?
We’ll discuss all this in more detail in the next article.
• This article is taken from our beginners’ guide to investing, MoneyWeek Basics. Everything you need to know about how to invest your money for profit, delivered FREE to your inbox, twice a week. Sign up to MoneyWeek Basics here