The price / earnings ratio is probably the most famous and most used financial ratio in the investment world. It is calculated by dividing the price of a stock by its earnings per share for a twelve months period. For example, a stock trading at $ 10 and having achieved $ 0.50 in earnings per share over the last twelve months will have a price / earnings ratio of 20 (10 / 0,50 = 20). While it is fairly simple to calculate, its interpretation has many subtleties. Here are some that must be taken into account to determine if the price / earnings ratio for a stock is attractive or not …
1. It’s relationship with future profits growth
Usually, the p/e ratio reflects the expectations of earnings growth for the coming years. A company for which the market predict 20% annual profit growth should trade at a p/e ratio around 20. A stock with low growth prospects will have a low p/e ratio. A common mistake is to consider every stock having a low p/e ratio as a bargain. Some of these stocks may be bargains but most deserve their low p/e ratio because of their the lack of net income growth. Another mistake is to overestimate the future growth of a company and thus purchase it’s stock at a p/e ratio that is way too high. We must also avoid to stupidly extrapolate past growth into the future (the past is no guarantee of the future).
2. It’s relationship with balance sheet
If the p/e ratio is based on future profits growth, the materialization of this growth depends largely on the financial flexibility of the company. Take the example of two companies (companies A and B) which are both promising a 20% annual profit growth for the next five years to their shareholders. Company A is heavily indebted, while company B has no debt and has ample cash. It is clear that company B is much better positioned to achieve its growth objectives and deserves a higher p/e ratio than company A.
3. It’s relationship with interest rates
The average price / earnings ratio of stocks depends on the interest rates. Investors are willing to pay a higher multiple for company net income when interest rates are low and vice versa. In general, the p/e ratio of a diversified stock index like the S & P 500 should have an inverse reltionship with interest rates. For example, if interest rates are 5%, the p/e ratio of an index like the S & P 500 should be around 20 (1 / 0, 05 = 20)
4. Profits visibility deserve a premium
Stocks of companies with good profits visibility are generally traded at higher p/e ratios. Profits visibility is the confidence that profits will be there in the years to come and will not suffer significant decrease. This characteristic is found mainly in large companies with strong competitive position such as Coca-Cola or Johnson & Johnson. Because of their profits visibility, these stocks are generally traded at a p/e ratio higher than their growth rates.
5. Be wary of cyclical businesses
Beware of p/e ratios of cyclical businesses. These ratios are often very low at the top of the cycle and very high at the bottom of the cycle. The reason is simple: markets do not give high profits multiple to cyclical stocks at the top of a cycle because they anticipate that their profits will decline in the coming years. On the contrary, the same stocks will be awarded high p/e ratios at the bottom of a cycle because the market anticipate that the sector recovery will generate strong earnings growth. A common mistake is to believe that a cyclical stock with strong earnings in recent years and trading at a low p/e ratio is a bargain. More than often, it means that we are close to the top of the cycle and the stock is ready to ride the downward slope of it’s sector …
6. Profit quality matters
The profits quality depends on how a company makes its profits. Are the profits resulting from conservative and prudent management or are they the results of high-risk / high-reward bets? In my opinion, profits generated by conservative management deserve a better multiple than profits resulting from riskier business. Always remember that profits reaped from risky business can disappear overnight if something goes wrong…
Related posts: