Chapter 20 – Valuation concept (P/E ratio)

Phew! Time to congratulate yourself for your effort on reading till now. Just a few more concepts and we are good to start practicing the art of investing.

Price-Earnings Ratio (P/E): This is one of the most commonly used numbers to describe the value placed by market on the company currently. It is calculated as below:

P/E = Price per share (Market Price)/Earnings per share (EPS)

The only difference is that the EPS used here does not adjust for extraordinary items as discussed in Chapter 17. We should adjust for those items so as to get a multiple corresponding to earning power of the underlying business.

What does P/E represent? The ratio is generally used as a multiple applied to the earnings which simplistically represents the number of years in which you earn equivalent of your capital, i.e. an investment of $100 grows by $100 to a total of $200.

Let’s look at an example. Assume you invest $100 to purchase 1 stocks of company XYZ with a P/E ratio of 12.5. This means that the company is earning $8 per share ($100 price per share/ 12.5 P/E Ratio = $8 EPS). Assume that the company continues to earn $8 per share every year and pays out as all of this earning as dividend to the shareholders every year. In this case, it would take 12.5 years to double the value of your investment ($100 collected in dividends + $100 of invested equity).

Similarly, for a company with a P/E ratio of 10 selling at $100 per share in market (i.e. the EPS is $10) – if the company continues to earn $10 per share in net income every year and returns this as dividend to shareholders, then the investor would be able to double the investment in almost 10 years time.

Needless to say, value investors look for relatively lower P/E ratios while evaluating when to invest in the company. Lower the P/E ratio, earlier the chance of earning back your capital. Do note that if the company doesn’t pay out 100% dividends as assumed in illustration above (most companies rarely do), it means that the net income is invested in other projects which might provide better returns and hence, a better chance of growing your capital faster. This is where knowing ROE and ROIC comes in handy for an investor.

Do we need to compare P/E ratio with anything? We should do two basic checks before investing in the company, assuming we like the company after analysing the fundamental factors discussed in previous chapters:

  • How does the P/E compare with overall market? If it is higher than the overall market (say S&P 500 Index for comparison with a US stock), we should probably refrain from investing in that company.
  • How does the P/E compare with other companies in same industry? If the P/E is higher than the peers, it is worthwhile to check the fundamentals of peers to understand whether the quality of business of the company in question is much better than the peers or whether there are higher expectations of growth in the future (and hence higher price to buy the stock).

Chapter 21 – Valuation concept (P/B ratio)

Chapter 19 – Cash flow statement (2)