How to use PE Ratios

The price-to-earnings (PE) ratio is one of the most simple and effective valuation metrics for investors to apply practically. For all of the perceived complexity in finance, this simple calculation has helped investors make money consistently for decades.

Backing profitable companies trading on low PE ratios, a crude definition of value investing, beat those trading at high PE ratios, often called glamour stocks, comprehensively over a period spanning 1952 to January 2015.

For first time investors, PE ratios offer a good starting point for working out where investment value can be found. Using PE ratios can also help ingrain investing discipline because they improve focus on underlying business performance, as opposed to share price activity.

Equally, seasoned investment professionals will regularly use more nuanced versions of the ratio as part of their decision-making processes to establish, for example, upside potential and downside risk.

 What is a PE ratio?

PE ratios can be calculated without the need for a degree in physics. Simply, it is:

Share Price

÷ 

Earnings per Share

The resulting ratio is higher for stocks with higher prices and lower earnings per share (EPS), and vice versa.

Forecast EPS is the most commonly used number for the ‘E’ in earnings. This is because the stock market on aggregate is trying to estimate the future earnings a business will deliver, rather than what it earned in the past.

These future earnings, combined with what they are used for (for example, dividends, share buybacks or capital expenditure), are what drive shareholder value in most circumstances.

Earnings forecasts are usually calculated by analysts after conversations with management teams based on current market conditions.

Often, analysts will simply apply a PE ratio to these forecasts in order to determine their price target for the stock. This is one of the more basic ways of arriving at a one or two year price target for a stock.

Historical earnings still have a role to play. They are often used in slightly different types of PE ratio calculations.

Remember, the price of a security multiplied by the total numbers of shares in issue is equal to the market value of a business. So another way of calculating a PE ratio is simply:

 Market capitalisation

÷

Profit after tax

Most data providers will have correct information on current market capitalisation and also profit-after-tax numbers for the last five, 10 or even 20 years.

Beware when using this latter method of businesses which have dual listings. Some of the UK’s largest stocks – BHP Billiton (BLT), Rio Tinto, Royal Dutch Shell (RDSB) and Carnival (CCL) are listed on two or more different exchanges. Often the market capitalisation displayed for these companies only includes the UK component of their total market value.

Cheap for a reason

In theory, a stock on a low PE ratio is considered cheap and a stock at a high PE ratio is considered expensive. In practice, stocks rarely trade at wide PE ratio differentials for no reason.

Perhaps the most common mistake made when using PE ratios is finding a stock which is cheap for a very good reason. Next year’s earnings might look good compared to the current stock price. But the year after that, earnings fall off a cliff and instead of having a cheap security, an investor ends up holding a stock that looks rather expensive.

Businesses with large pension deficits also often trade at discounts to the wider market.

Finally, investors should also be careful about comparing PE ratios across sectors. Mining companies, banks and technology firms all very different types of business with varying accounting policies. Cross-sector comparisons can only ever be a rough approximation of the relative value on offer.