What you need to know about the p/e ratio
By
Deputy Editor
Tim Bennett Aug 09, 2007
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Simple to calculate and widely quoted, when it comes to share investing, the price to earnings ratio (PER) is still the king of ratios. The dotcom years of the late 1990s spawned a few pretenders designed to put a value on the era’s many loss-making tech stocks – EV/ebitda, for example – but none have had the same staying power.
However, no ratio is perfect and like most simple things the p/e ratio can be misleading if used incorrectly. So, what should you watch out for when working it out, and what does it really tell you?
How to work out the p/e ratio
The starting point is the “current” p/e ratio; either divide the latest share price by earnings per share (EPS, at the foot of the profit and loss account), or the market capitalisation (number of ordinary shares multiplied by the share price) by net profit. So, if the current share price is £10 and EPS is £1, the p/e ratio is ten. Doing this calculation every day for lots of companies could get tiresome, but you can easily find the numbers on several websites, including Digital Look, and also at the back of the FT.
However, that isn’t all there is to it. The above p/e ratio is a historic measure. It tells you how long it would take to make back your initial investment in the company if it keeps generating the same earnings that it did in the past year (in this case, ten years) – but there’s certainly no guarantee that this will happen. This is why analysts’ reports and websites usually quote two p/e ratios – the one described above and a “forward” p/e ratio, which uses the current share price, but this time divided by an estimated figure for next year’s earnings. This is particularly useful when last year’s profits were distorted by a one-off event, such as a large asset sale or writedown.
The forward p/e ratio is also helpful when a company is emerging from a period of losses (since dividing a share price of £10, for example, by a “current” EPS number of -£2 gives a meaningless result of -5). A good example is Colt Telecom (COLT), which made a loss of e0.03 per share in 2006, so has no historic PER, but has a forward PER of 67, based on analysts’ predictions for a return to profit this year.
How to use the p/e ratio
So you know what the p/e ratio is – but what does it tell you? Concluding that a company is a bargain on a PER of ten, with no comparative, is as meaningless as saying that a car costing £10,000 is cheap. Even if the average car costs less, £10,000 would be a bargain for a Porsche, but something of a rip-off for a second-hand Fiat Panda. So what should a company’s p/e ratio be compared with?
The market
Starting from the top, the p/e ratio can be a useful guide to the value of market as a whole. Right now, Morgan Stanley calculates that the median p/e ratio for the top 350 UK-listed companies (taking the middle value from a straight ranking of all the individual p/e ratios) is 19. They claim that whenever this figure has risen above 18 in the past – examples include October 1997, the spring of 1998 and 2006 – a correction has soon followed.
But look at the figures in more detail and straight away you can spot where the trouble will come from. FTSE 100 stocks have an average p/e ratio of around 13, whereas FTSE 250 stocks are on 19. That’s a 50% premium – why? Well, as James Ferguson points out in Model Investor, the level of private-equity interest in mid-cap stocks has bid up prices across the board, making many of these stocks unattractively expensive. The largest FTSE 100 stocks, on the other hand, are deemed too big for a successful private-equity bid and have not attracted this premium. This makes them less vulnerable to a steep slide.
The sector
Sticking with big companies, if oil stock profits are booming on the back of the strong oil price, then why is BP (BP) only on a p/e ratio of 12? Indeed, why is the whole oil sector only on a p/e ratio of 11.5? It all comes down to what you believe will happen to the oil price in the future. If you reckon, as we do, that the price of oil will continue to rise as global demand outstrips supply, then these low valuations make oil stocks a very good bet, as profits are likely to keep rising. But even now, many analysts believe the current high oil price is unsustainable – and if it was to fall, so would oil company earnings. If that’s your opinion, then their current rating could be seen as fair rather than low.
The company
If you have decided that you like FTSE 100 companies and you think oil stocks look cheap, the final step is to find a bargain within the sector. Here, looking at past valuations can be a useful starting point. For most stocks, Morningstar gives a five-year p/e ratio that, once averaged, can make a useful benchmark. On this basis, BP is still not expensive; its current p/e ratio of just under 12 compares with a five-year average of 14.
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