EXPLAINED: PE RATIO What, Why, How and Why?
In this article, I want to explain a very important share ratio that is used in Fundamental Analysis… I will do this with a Ask Question then Answer Approach… It’s to the point and useful for you to save…
What is the PE ratio?
The price-to-earnings ratio or P/E is a financial ratio used to evaluate a company’s share.
How is it calculated?
Current market’s price / Earnings Per Share ( EPS ).
Share price / EPS
What does it show you?
It shows you whether a company’s stock (based on its earnings ) is:
Overvalued or Undervalued.
Also, it gives an indication on how many years it will take for the earnings of the company to equal to the share price.
What does a HIGH PE show?
• A very high PE could mean the share may be overvalued.
• Investors are paying more for each rand or dollar of earnings .
• It will take longer for the investors to recoup their investments.
What does a LOW PE show?
• Share may be undervalued.
• This could signal a buying signal for investors.
• Or it could signal danger as to why investors aren’t buying the share price up.
What are the advantages of a PE?
1. Gives an indication on how long it will take to make up for the investment.
2. Can signal buying opportunities in some shares.
3. Can give you an example of what one company’s PE ratio is in comparison to other shares in its sector.
What are the disadvantages of a PE?
1. Does not take into account of the company’s growth or future earnings potentials (You’ll need the PEG ratio).
2. Doesn’t include the company’s dividends
3. Doesn’t take into account of the other financial indicators.
Note: You need to use other ratios and financial indicators to base a decision. PE isn’t good enough. The PEG Ratio is more reliable as it takes into account the growth rate of the PE over the years.
Example of an Overvalued PE ratio:
Share price R200
EPS ( Earnings Per Share): R10
P:E Ratio = 20 (R200 / R10)
This means investors are willing to pay R20 for every R1 of the company’s earnings . Or they are willing to pay 20 times more than what the EPS is.
This is unstable as what the company is priced at versus what the investors have priced the company at could result in a bubble.
And so it can get to the point where investors start selling their stock which will cause a drop in price.
Also, the P:E ratio states it will take 20 years for the investors to get their money’s worth.
However, if the prospects are good and the company is showing strong future growth, this could be a reason why investors are paying a PREMIUM for their stock.
Example of an Undervalued PE ratio:
Share price R100
EPS ( Earnings over the share price): R25
P:E Ratio = 4 (R100 / R25)
This means investors are not willing to pay a higher price for the company’s earning. In this case, they are only paying 8 times more than what the EPS is.
This could indicate that the company is going through financial difficulties and is NOT expected to grow.
However, it’s not easy to calculate what a HIGH or LOW PE ratio is for just any company. This is because you need to compare it to their competitors and peers.
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