So, what is P/E ratio?
P/E is an abbreviation for price / earnings and is one of the most common key figures used to see if a share is worth buying or not. Price stands for the share price and earnings stand for the company’s profit. The key figure thus shows the price of one share in relation to the company’s earnings per share. Earnings per share are the company’s total earnings divided by the number of shares in the company.
How do you calculate P/E ratio?
You calculate a company’s P/E ratio by dividing the share price by the company’s earnings per share.
How is it used?
Simply explained, they say low P/E = cheaper, high P/E = more expensive.
The Swedish stock market as a whole usually moves between 15-20 in P/E, which can help as a starting point in your valuation. Not sure about the American Stock Market, but probably similar.
Investment inc. has a P/E ratio of 10, this means that you pay 10x the annual profit when you buy the share and theoretically it will take 10 years before the company has earned your invested money. However, this is a highly theoretical assumption then.
First, as a shareholder, you may not withdraw the earnings per share, but there is money left in the company to be partially distributed to shareholders but also to invest and amortize for the future.
Secondly, earnings per share are seldom the same every year, but the hope is that earnings will steadily increase over time.
The opportunity for increased profits in the future is exactly what attracts with high P/E figures.
More practically, you use the P/E ratio to see what the market (You and all other investors together) are willing to pay for the stock right now. Low P/E indicates that the market is putting a low / cheap price on the profit right now.
Larger, more stable companies tend to have low P / E ratios, as they have a well-functioning business model and stable earnings.
Smaller and more start-up companies often have a high P/E ratio as they do not yet make that much money.
These companies are bought in the hope that profits will increase in the future and thus accept a more expensive price today.
This means a higher risk as the market now expects a sharp increase in profit, if that increase is not made, the share can fall sharply.
To sum up, low P/E theoretically means cheaper and lower risk.
High P/E theoretically means more expensive and higher risk, which is acceptable if you have a starting confidence in the company’s future profit increase.
How to calculate P/E:
Why use P/E ratios?
When trying to decide whether to buy a share or not, ie when valuing it, the P/E ratio can be useful because it shows how high or low the market values the stock.
Then you always decide for yourself if you want to buy a share that the market already values highly, or if you want to try out and try to find shares that the market values low, but which you yourself believe in.
Pro Tip when using P/E ratio
The most common way to calculate and use P / E ratios is to look at previous annual profits, because you then use the actual profit that the company has had.
When you instead use future profits to calculate the key figure, you simply guess what you think the company will get in profit, and this of course means that the whole thing becomes more speculative.
What does a P/E ratio show?
This key figure actually shows how many annual profits the market values a company for, or how long it takes to get back its investment, provided that the company’s profits are as high as when you bought the share.
If a P/E ratio is 10, this means that it takes 10 years before the company has earned back the same amount that you paid when you bought the share.
It is basically about the market’s expectations of the company.
A high P/E ratio can mean that the share is overvalued or that the market has high expectations of the company and expects it to continue to deliver good and stable profits or dividends.
A low figure may instead mean that the share is undervalued or that the market has low expectations of the company and its future.
It can easily be said that the market is trying to predict the company’s future profit which is E (earnings) in the equation.
That belief is today reflected in P (price) which is the share price.
If the market expects a company to increase profits, the market will take note of it today and vice versa, it can be said that expectations are reflected in the share price.
How does the market value profits in a company?
There is no crystal clear answer to that question. On the other hand, it is common for the market to continuously value stable revenues highly.
Companies that operate in industries with revenues that are more uncertain over time usually receive a lower valuation.
It can be said that the “quality” of revenues is worse if they fluctuate a lot. It can be good to think about the type of income a company has when assessing whether the P/E ratio is high or low.
The fact that two companies have the same P/E ratio does not mean that they are as cheap or expensive, but it depends on how the market values the profits of the different companies.
Steel Company Inc. is active in the steel industry and is dependent on global demand for steel.
When the global economy is doing well, it usually means high demand for steel, which in turn leads to higher prices, and Steel Company sees its profit rise sharply.
When the global economy is weak, on the other hand, demand for steel declines.
Less is being built, and many companies and countries are saving money by postponing purchases. The steel company still has large factories and staff to pay for, but when revenues decrease rapidly, the company’s profits also fall.
Food Company Inc, on the other hand, is active in the food industry and has various grocery stores around the country.
Food is something that is always in demand, regardless of whether the economy is strong or weak. This means that the Food Company has a steady demand and revenues are more stable than Steel Company Inc.
The market often values the Food Company’s profit higher than the Steel Company, precisely because it is stable and more predictable.
This leads to Food Company Inc. having a higher P/E ratio.
How do you use P/E ratio?
You can either use only the P/E ratio or combine it with other key ratios.
There is no general rule of thumb on how to use the number, but many people use it to find companies that are valued low in relation to actual or expected profits.
It can also be interesting to look at how a company is valued based on P/E ratios in relation to how they have historically been valued to find over- or undervalued shares to buy or sell.
Can you use the P/E ratio in your investment strategy?
Many use this key figure as a benchmark against the company’s competitors.
Some investment strategies involve buying undervalued companies that are believed to deliver good profits in the future but which for some reason are not fully visible in today’s valuation.
Within these strategies, one looks at the P/E ratios for the various companies.
The fact that a company has a low P/E ratio in comparison with its competitors indicates that the market values that company low.
Some investors see this as an opportunity to buy shares in a company that has potential.
Of course, it requires the investor to believe in the company and its future prospects. It is a risky strategy that can go well as well as less well because there are often reasons why the market values the company low.
Therefore, in these situations it is an advantage to be a little more familiar with the company.
Pro Tip: P/E Ratio
You get the best idea of a company and the valuation of it if you compare the P/E ratio in relation to other companies in the same industry.
Comparing companies in different industries is like comparing apples and pears as different industries are affected by different factors, which in turn affects the companies’ profits and thus the P/E ratio.
Profits are also valued differently in different industries depending on how stable it is.
What is a high or low P/E ratio?
As previously mentioned, the P/E ratio gossips about how many annual profits the market is prepared to pay for a company, ie how many annual profits the company is valued at.
The average for the last 100 years on the Stockholm Stock Exchange is around 14 * (not sure what it is on the American Stock Exchange).
Larger and more mature companies that no longer grow so fast generally have lower P/E ratios than smaller companies that grow rapidly as the market expects rising profits as the company grows.
A company that has a P/E ratio above the average on the stock exchange may be overvalued, but it may also be the case that the company grows faster than the average company on the stock exchange and that the market therefore values the company higher than its competitors.
It can be interesting to look at what a specific company’s level has been historically and see if today’s level is higher or lower to get a good idea.
What does it mean when a P/E ratio is negative?
If a company makes a loss, it is not possible to calculate the P/E ratio because there is no annual profit to set the price in relation to.
However, it may be that a company makes a loss today but is expected to make a profit next year.
Then you can guess what that profit will be and calculate an expected P/E ratio on next year’s profit. You can also use the P/S ratio to see how the market values the company – then you look at the price in relation to sales instead of profit.
P/S ratio video explanation:
Summary of P E Number
By analyzing financial data in several companies, you as an investor can create a good picture of shares worth buying.
Among other things, by examining the company’s profit and calculating key figures. One of these is the P E number, a ratio where P stands for price and E for earnings.
The abbreviation stands for price earnings and this is how industry people call it.
The calculation is made according to the formula below:
Stock price / Earnings per share
To calculate the ratio, place the share price in the numerator and divide by the company’s profit, per share.
If the company makes a good profit, the value of the denominator increases and the quota becomes relatively lower. It gives you as an investor a better opportunity to make a profit on your investment.
A company with a low profit usually gets a higher quota.
In other words, low p e is in theory desirable. But you should not stare blindly at p number and e, but combine the analysis.
What is a good p / e figure is therefore very difficult to say, but interpret it yourself and improve the probability of making a profit on your investments.