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Understanding P/E ratios

Q. I keep reading about and hearing financial commentators and brokers talking about P/Es for shares and it always seems important but I don’t understand why. Should I know about this to buy shares? Could you explain please? 

A. The price/earnings ratio or P/E is important as a measure of whether a share or an overall stock market looks like good value of not. The price (P) bit is the price of the share and the earnings (E) bit refers to the earnings per share. The latter equates the profits of a company to the number of shares out there. The P/E is good for comparing a stock against another and it can be a measure of valuation — whether it’s undervalued or over-valued. Myer, for example, is coming to market with a P/E of around 17 and this was the reaction of Martin Duncan, an investment analyst with Fortis Investment Partners, in a Reuters article: “There's no way they can bring Myer to market at the same P/E as DJ's. There's got to be some sort of IPO discount.”

Newspapers that have a good business section will publish the average P/E for the overall stock market and these can be used if you are thinking about buying into ETFs or index funds, which give you an exposure to the stock market in a general sense rather than a share specific sense. When the stock market was at its low point in March, the P/Es of many companies were low and the overall stock market’s average P/E was also low and that would have given courageous long-term investors the signal to buy into the market. In simple terms, if the price of a share is $10 and the earnings per share is $1, then the P/E would be 10. If the market gets excited about the stock, it’s price could go to $20 and if the E stays at $1, the P/E would now be 20. Divide this into a 100 and we would say a P/E of 20 is equal to a 5% return. At 10, the return was 10%. When a boom gets too excitable P/Es get over 20 and that’s when some investors look at rising interest rates on safe fixed bank deposits and so shares get sold as money goes into bonds. This can spark a correction or even a crash. So, if P/Es get too high and interest rates get over 5%, it’s time to think about how long you want to be heavily exposed to shares. These are general rules of thumb and some companies can have big P/Es because their share price keeps delivering great capital gain, but they are more exceptions to the rule. 

Book a complimentary first appointment with Switzer Financial Services today. 

 

Important information:This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

 

Published on: Friday, October 30, 2009

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