How to Use the Price-to-earnings Ratio

Have you ever wondered how professional investors pick their stocks? For most people, investing in the stock market is a scary and daunting venture. We have all heard stories before about people who lost all their savings by making stock investments that seemed like great opportunities at first but later turned out to be costing money instead.

There is so much that can go wrong when you start investing. Even if you are absolutely sure that your selection of stocks has no bad apples in it, who is to say you will actually make a profit? Good investments are a combination of:

• strong fundamental analysis
• accurate timing
• correct selection of investment vehicles
• proper hedging

Fundamental analysis is probably the most important but also the most time consuming part of your research. Over the course of this series, we will make you familiar with the basics of fundamental analysis, starting with an introduction of one of the most widely used ratios in company valuation, the P/E ratio.

What is the P/E Ratio?

The P/E ratio is a ratio that gives you an indication whether the current price of the stock is in proportion to the earnings the company has generated in the last year.

Sounds complicated? Let’s take it back a couple of steps:

When you invest in a stock, you want to see a return on your original investment. This can happen through various ways, but the two most common reasons you will realize return on your original stock investments, is either through an appreciation in the stock price (capital gains) or through the payment of dividends (dividend yield) by the company. You want to make sure that your money can benefit from as much capital gains and dividend yield as possible.

The P/E ratio tries to capture how much investors are willing to pay for every RM 1 of earnings. Let’s say that a company has a P/E ratio of 20. That means that the price of the stock is 20 times higher than the earnings per share. Or, in other words, investors were willing to pay RM 20 for RM 1 of earnings. In itself that won’t say much but if you benchmark that against past results or industry competitors you can get a clear picture of how investors value the company.

As investor you always want to look for the lowest P/E ratio because that would mean the highest earnings compared to how low the stock price is.  If the P/E ratio of a company is higher than the average P/E of industry competitors, the stock could be overvalued. If the P/E ratio is lower, the stock could be undervalued. Investors typically invest in stocks that they expect to go up in the future. If you buy a stock with a low P/E, your returns will be proportional to that P/E ratio, regardless of what happens to the stock price. If the stock appreciates, the P/E ratio will go up, but that won’t affect your returns since you bought in at a lower P/E.

That is why undervalued stocks are so attractive. Next to having higher than usual dividend yields, they are also more likely to appreciate in the future.

The P/E ratio can be used as a quick assessment of how much return you can expect in the short term, and it can also indicated a direction for the stock price.

How to use P/E as an indicator of short term returns

If a company has a P/E ratio of 20, you would have to invest RM 20 to make the company earn RM 1. If the company has a dividend payout ratio of 0.5, it will pay 50% of that RM 1 back to investors. That means that for every RM 20 invested, you stand to make RM 0.50. Which translates to a return of 2.5%, excluding any tax and transfer fees.

How to use P/E as an indicator of short term stock price movement.

If the P/E ratio is relatively low, the stock could be undervalued and could therefore appreciate in the future. On the other hand, if the P/E ratio is high, the stock could be overvalued and could see a drop in the near future.

However, a high P/E ratio could also indicate that investors expect to see significant growth in earnings in the future, for example with growth stocks. In this case the stock price has already appreciated in anticipation of higher earnings. That being said, a low P/E does not always mean a good buy and a high P/E does not always mean a bad buy. For example, a low P/E could also indicate that the stock price has dropped severely compared to earnings. In this case, you should ask yourself what is driving the stock price down.

If it is just market sentiment, then the stock will likely pick up in the future, but if the cause is structural then the company might actually go bankrupt. Similarly, a high P/E does not necessarily have to be bad. If the company is planning a move overseas to a market where their P/E ratio is not that high, the stock might actually be a good investment. All of this is of course not set in stone, and you should not use the P/E ratio as your exclusive indicator of stock price movement.

How is the P/E ratio calculated?

The P/E ratio is a division between two numbers, the P, which is the current price of the stock and the E, which represents the earnings per share of the company.

The current price of the stock

The price of the stock is determined by supply and demand in the stock market. If investors think the stock is overpriced they will buy less and if it is under-priced, they will buy more. This effect causes the stock price to always be a representation of how investors value the company.

The earnings per share (EPS)

The earnings per share are calculated by dividing the annual after-tax earnings of the company by the amount of common stock outstanding. Usually this number is given in the annual and quarterly reports that company issue. EPS is indicative of how much earnings the company generated compared to how many shareholders the company has. EPS is one of the most important earnings ratios and is very important in determining your dividend yield.

How to Use the P/E ratio

Let’s see how we can use the P/E ratio to analyze the 30 companies listed on the FTSE Bursa Malaysia KLCI. This list is comprised of the 30 companies listed on the Bursa Malaysia that have the most market capitalization. Market capitalization is the multiplication of the stock price times the number of shares outstanding, and indicates the size of the company.

The list includes a lot of large conglomerates that cannot be classified into one specific business sector. However, there are specific sectors, such as banking and telecom, which quite clearly have a similar P/E ratio. If you look at the banking sector, highlighted in the table above, you can see that all their P/E ratios fall between 10.5 and 14.8.

In this case, the P/E ratio gives you much more usable information than just the share price or the earnings per share.

For example, even though there is a big difference in the share price of Hong Leong Bank and Malayan Banking (13.78 and 8.97), the P/E ratios are pretty similar (12.8 and 13.2) which shows that the proportion of share price to EPS is very similar for both companies.

However, the dividend yield for Malayan Banking is much higher than Hong Leong Bank, which indicates that Malayan Banking pays out a higher percentage of its earnings as dividend. There is not one bank that specifically jumps out as having a disproportionately high or low P/E ratio. If that were the case, it could be a first indicator that the stock is over or undervalued.

Limitations of the P/E ratio

Like many of the individual ratios that are used to value companies, the P/E ratios comes with several limitations that should be taking into account when using the ratio to make investment decisions.

The P/E ratio cannot be used across industries

The P/E ratio cannot be used to compare companies from different industries because different industries have widely different business models and growth rates. For example, if you would compare the P/E ratio of a telecom provider and a financial service provider, you would conclude that one is clearly the better investment, even though that might not be necessarily the case.

The P/E is influenced by financial leverage

Almost all publicly listed companies have significant amounts of outstanding debt. This debt has a significant effect on both the share price and the EPS, and therefore the P/E Ratio.  The company with less debt is most likely to have a low P/E ratio and therefore seem like a better investment.

However, if business is going well, a company that uses more debt could generate more earnings because it assumed more risk. The P/E does not take risk into account and therefore rates companies with higher debt lower, even though they are usually able to generate higher returns on equity.

A company with a high debt to equity ratio typically has more growth potential because it can buy more assets and therefore scale up faster than a relatively debt free company. Because of the increased chance of growth, the stock price will be pushed higher than earnings would warrant.

Additionally, the higher debt increases the interest payments for the company, which reduces earnings. Reduced earnings and a higher stock price make the P/E ratio seem worse than it actually is.

The Stocks' earnings data can be unreliable.

In most of the world there is still a lot of freedom in how companies are allowed to report their earnings information. Through smart accounting, companies can tweak their income statements to present lower earnings than were actually realized to avoid taxes. If you then use this data when calculating the P/E ratio, you might get a skewed result because actual earnings are higher than presented.

What you need to remember

• The P/E Ratio is calculated by dividing the current market value of the stock by the companies’ earnings per share.

• A low P/E Ratio means that the investment return is higher than usual and the company could be undervalued.

• A high P/E Ratio indicates that the return is lower than usual and investors expect the return to increase in the future. The Stock could also be overvalued.

• The P/E Ratio can only be correctly interpreted when compared against companies in the same sector or against historic P/E ratios from the same company.

• The P/E ratio can be distorted by the debt-to-equity ratio of the company. Companies with lower debt typically have lower P/E’s than companies with higher debt.

• The P/E ratio can be influenced by accounting standards. The way companies report earnings might have an effect on the P/E ratio.

The P/E ratio can be a great tool in helping you make good investment decisions, but don’t use it as your single measure of value. Always take into account these stockpicking basics and check out this article on how to pick stocks to invest in.

If you have a good system going and you feel like you replicate your returns consistently, you can use a personal loan to leverage your capital into even more investment returns! You can use our free comparison tool to find a personal loan that suits your needs. Good luck!

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