The price/earnings ratio is one of the most important financial ratios we can calculate for a company that’s traded on the share market. It is calculated by dividing the share price by earnings per share.
For example, Chorus Ltd, currently trades at $2.94 per share. It has earnings per share of $0.265. 2.94/0.265=11.09. This is different than the figure shown below because I used the current price rather than the opening price.
In effect, if you buy 1 share of Chorus for $2.94 (excluding brokerage), you are purchasing underlying earnings of $0.265. You won’t necessarily get all of this as a dividend, but the 11.09 ratio allows you to compare different companies share price in relation to their earnings per share.
The P/E ratio can indicate whether a share is undervalued or overvalued. That doesn’t mean its share price will have anything to do with its valuation, but can help identify speculative bubbles.
In order for a high P/E ratio to be justified, a lot of earnings growth must be anticipated. If that growth in earnings per share doesn’t eventuate, a bubble stock can quickly collapse.
Because of the incentives faced by executives of publicly traded companies, increasing earnings per share each quarter is very important. The long term profitability of their business can take a sideline to making sure they “hit the numbers” that research analysts forecast for the company.
In the Dotcom bubble of the late 1990’s and early 2000’s, some companies achieved very high share prices without any underlying earnings growth. Their P/E multiples were very high – some companies were even making losses and burning through shareholder wealth at a rate of knots.
We have to remember that calculating ratios like these and making investment decisions based on them is risky business. Because of the casino nature of the financial markets these days, the most useful thing a P/E ratio can do is help us avoid piling into a bubble stock.
It can also help us avoid buying a dog on the cheap, because we think it is “under valued”. While the efficient markets hypothesis is academic fantasy, a lot of information is contained in the price of a share. If it’s going cheap, there’s probably a solid reason behind it.
Take for example Telecom – which of course used to have Chorus before regulatory action forced structural separation in the New Zealand telecommunications market.
We take the current price of $2.275 and divide that by earnings per share of $0.536 which gives us a price/earnings ratio of 4.24. This is much lower than Chorus’ p/e ratio of 11.09.
What does this actually mean? Well, traditional finance thinking would say that Telecom is undervalued because the price/earnings ratio is so low. Robert Shiller, in his book Irrational Exuberance, posits a long term average P/E ratio of 15 for US stocks.
While it’s hard to apply US data to a New Zealand market, on a global scale, both P/E ratios are low. That’s because New Zealand is not the United States. There are many risks that lower the premium investors will pay for New Zealand earnings.
- New Zealand has currency risk, because investments are denominated in NZD.
- New Zealand has political risk, because the telecommunications sector has been heavily regulated over the past decade.
- New Zealand has volatility risk, because we’re like a lifeboat in the South Pacific – movements in overseas markets can very much influence our markets.
A value investor, someone who thinks share prices will move towards their actual value as opposed to the market price, would prefer Telecom to Chorus because of the lower P/E ratio.
A trader, someone who thinks the market price is all that matters, might think Chorus is preferable to Telecom because the higher P/E ratio means more people think that way and it’s still not “overvalued” so there’s potential upside.
Price / earnings ratios matter because they can influence the decisions of a lot of people. Some superannuation funds might have rules that stop them from paying a premium for underlying earnings growth. Executives at the firm might even engage in accounting games to show steady EPS growth.
When it comes to making investment decisions, how you view the results from calculating things like the price/earnings ratio will inform your eventual decision. But we shouldn’t forget that there are lots of factors outside the model that affect ratios like this.
These include regular buying from institutional investors that must own the share to track the index their performance is benched to. It also includes the company itself engaging in Treasury buybacks where it purchases and cancels its own shares to increase earnings per share.