As a long-term investor, you've likely heard about a P/E ratio when investing in shares. But what does it mean, and why should you care? Understanding the P/E ratio can potentially help you make better investment decisions. It's a simple yet powerful tool used by many investors. Using the P/E ratio, you can assess if a share is a good buy for your portfolio.
In this article, we'll dive into what the P/E ratio is, how to calculate it, and what makes a “good” P/E ratio. We'll also explore historical examples and see how this financial ratio fits into long-term investing. After reading, you’ll hopefully have a clearer idea of how the P/E ratio can inform your investing journey.
Definition: what is a P/E ratio?
There are a lot of acronyms floating around the investment world, and it can sometime feel hard to keep up. Let’s demystify one of them now – the P/E ratio. The term stands for "price earnings ratio". In other words, it compares a company's share price to its earnings per share. This ratio shows how much investors are willing to pay for each dollar of earnings.
To understand it better, let's break it down. The "P" in P/E ratio is the current stock price. The "E" is the earnings per share, which is the company's profit divided by the number of shares.
Among other tools, the P/E ratio enables investors to assess a company’s value. It can help you decide if a share is overvalued, undervalued, or fairly priced.
How to calculate the P/E ratio
Calculating the price earnings ratio is simple: you divide the current share price by the earnings per share (EPS). To get these numbers, you can check the company's financial reports or use financial news websites. It's important to use the most recent data for accuracy.
Here’s a step-by-step example of how to calculate a P/E ratio:
- Find the current share price. Let's say it's $100.
- Find the earnings per share. Suppose it's $10.
- Divide the share price by the earnings per share. In this case, $100 / $10 equals 10.
So, the P/E ratio is 10. This means investors are paying $10 for every $1 of earnings the company makes. The price earnings ratio can also be calculated by dividing a company’s market capitalisation by its net earnings.
Understanding this calculation can help you see how much value the market places on a company's earnings. This insight can then aid in making informed investment decisions.
What is considered a good P/E ratio?
It depends. A “good” price earnings ratio can vary depending on the industry group and market conditions. Generally, a P/E ratio between 10 and 20 is often seen by investors as reasonable.
Interpreting P/E ratios
A high P/E ratio is typically above 20. This might mean investors expect strong future earnings growth. On the flip side, a low P/E ratio is usually below 10. This could suggest the shares are undervalued or the company is facing challenges.
Different industries have different average P/E ratios. So it’s important to compare P/E ratios within the same industry group. For example, tech companies often have higher P/E ratios than manufacturing companies due to growth expectations. Comparing P/E ratios within the same industry can provide more accurate insights into value and performance. Market conditions also influence P/E ratios. During bull markets , P/E ratios tend to be higher. In bear markets, they are usually lower.
Historical examples of good P/E ratios
Let’s go back in time to look at some real examples of company shares with good price earnings ratios.
Example 1: IBM
In the early 1980s, IBM had a P/E ratio of around 15. This was considered attractive because it reflected solid earnings and expected growth potential. During this period, IBM was a leader in the mainframe computer market and invested heavily in research and development. Their innovative products and strong market position made investors confident in their future growth prospects, leading to a reasonable P/E ratio.
Example 2: Coca-Cola
Coca-Cola had a P/E ratio of about 18 in the mid-1980s. This was viewed as good because Coca-Cola consistently delivered strong earnings. During this time, Coca-Cola was expanding its global presence and had launched several successful marketing campaigns. The company's strong brand recognition and steady revenue growth from international markets boosted investor confidence, resulting in a higher P/E ratio.
Example 3: General Electric
General Electric (GE) had a P/E ratio close to 12 during the 1980s. This mid to low P/E ratio indicated that the shares were relatively cheap compared to earnings. GE was known for its diversified business model, spanning from industrial manufacturing to financial services. During the 1980s, GE experienced steady earnings growth under the leadership of CEO Jack Welch, who implemented efficiency improvements and strategic acquisitions. This steady performance made GE a popular choice among investors.
A “good” P/E ratio also depends on context. As mentioned earlier, historical averages show that P/E ratios between 10 and 20 have often been considered good. However, markets change. Always consider the broader market context before making any decisions. Current market conditions and industry trends can significantly impact what’s seen as a favourable P/E ratio.
The role of the P/E ratio in long-term investing
The price earnings ratio can help you determine if a share is fairly priced compared to its earnings. By comparing the price you pay to the company’s earnings, you can seek to measure market expectations and potential value, which can influence your long-term investing strategy.
Limitations of the P/E ratio
While useful, the P/E ratio has limitations. For starters, it doesn’t account for future growth, debt levels, or market conditions. High P/E ratios might not always indicate growth, and low P/E ratios might not always signal undervaluation. It's essential to consider these factors alongside the P/E ratio.
How different investors use the P/E ratio
The P/E ratio is a versatile tool that can be used in various ways depending on an investor’s style and goals. Here’s how different types of investors might use the P/E ratio:
Value investors
Value investors look for companies with low P/E ratios. They believe these companies are undervalued by the market and have the potential for price appreciation. While it can sometimes suggest internal problems, a low P/E ratio may also signal that a share is a bargain compared to its earnings.
Example:
Jose is a value investor. He finds a company with a P/E ratio of 8, lower than the industry average of 15. He sees this as a buying opportunity, believing the market has overlooked this company’s potential. He expects the share price to rise as the market recognises its true value.
Growth investors
Growth investors want capital growth and look for investments with a growth orientation. As such, they tend to focus on companies with high P/E ratios. They’re willing to pay a premium for shares in companies with high growth potential. High P/E ratios can indicate that investors expect significant earnings growth in the future.
Example:
Emily is a growth investor. She identifies a tech company with a P/E ratio of 30, higher than the industry average of 20. She believes this company will grow rapidly, outpacing its competitors. She therefore invests, expecting the company’s earnings to increase and justify the high P/E ratio.
Income investors
Income investors tend to prioritise dividend returns . With this in mind, they may use the P/E ratio to ensure they are not overpaying for shares. They generally prefer companies with stable earnings and reasonable P/E ratios.
Example:
Sarah is an income investor. She looks for companies with a steady dividend history and a P/E ratio around the market average. She finds a utility company with a P/E ratio of 16 and a reliable dividend yield. She invests, aiming for consistent income without overpaying for the shares.
Defensive investors
Defensive investors seek to minimise risk. They can use the P/E ratio to avoid overvalued shares that might be susceptible to market corrections. These investors tend to prefer companies with moderate P/E ratios, indicating stability.
Example:
Ghin is a defensive investor. He avoids companies with very high P/E ratios, believing they might be overvalued. He finds a consumer goods company with a P/E ratio of 14, reflecting steady earnings and a strong market position. He invests, aiming for stable returns with minimal risk.
As you can see, the P/E ratio can be a helpful tool to assess company value for long-term investing. Knowing how to use the P/E ratio based on your investing style can help you align your investments with your financial goals. However, relying solely on the P/E ratio can be misleading. Consider combining it with other metrics for a more comprehensive view.
Different performance metrics for different investors
Investors have different goals and preferences, and therefore value different metrics. Here’s a look at key metrics other than the price earnings ratio and how they suit various investment styles:
- Dividend yield shows the return a company pays out in dividends each year relative to its share price. Income-focused investors often prefer shares with high dividend yields.
- The price-to-book ratio (P/B ratio) compares a company’s market value to its book value. Value investors use this metric to find undervalued shares.
- Return on equity (ROE) measures a company’s profitability relative to shareholders' equity. Growth investors tend to favour high ROE as it indicates efficient use of equity to generate profits.
Each metric offers a piece of the puzzle, an no single metric should drive your investment decisions. Consider the company’s overall health, industry trends, and market conditions. Historical performance and future prospects matter too. Using a combination of metrics provides a fuller picture, helping you make more informed decisions. Remember, the best strategy is one that aligns with your personal investment goals and risk tolerance.
Understanding the P/E ratio – keep learning
Getting to know the price earnings ratio is a great start, but investing is a continuous learning process. The more you know, the better decisions you can make. The market constantly changes, so staying informed can help you adapt and make smart choices.
Investing isn’t about knowing everything at once. It’s about gradual learning and applying that knowledge. The P/E ratio is a useful tool, but as we’ve noted, it’s just one piece of the puzzle. Combine it with other metrics and stay informed. This approach can help you make well-rounded, confident investment decisions.
Your investment journey is unique. Keep learning, stay curious, and use the tools and knowledge you gain to build a strategy that works for you.
