The PE Ratio: A popular measure

A very famous measure of calculation in the investment industry is the PE Ratio. The PE Ratio is the Price per share to Earnings per share ratio. It represents a certain number which can tell whether a stock is priced too expensive or cheap. However, it is more deep than just a representative number and the reason behind the number can often be profound.

If a stock was earning 20 cents per share a year and the share was selling for 1 dollar, then its PE Ratio is 5. if you had bought the stock at 1 dollar, and assuming the earnings of the share does not change for 5 years, and they paid out all their earnings as dividends then it would take 5 years for you to earn back your capital. That's a 20% per annum yield which is pretty high. Sometimes they need not pay out the earnings as dividends but will be retained within the company, and it would reflect the increase in share price, assuming the PE Ratio stays the same. Sometimes though, the market might go crazy like Mr.Market and drive prices too high or too low.

A great company is a company that maximises shareholder value and does things that achieve that. You'd be surprise at how many companies are actually doing the opposite of that. They're run by managers who might not be owners of the company, and all they want to do is expand, acquire and go international. That might not benefit the shareholders whom are the owners of the company. To put it simply, if the company has no better use of the shareholder's money then it'd be better off paying it all out as dividends. Otherwise, they would reinvest the money back into the company for growth or expansion that would benefit the shareholders and be reflected in the increase in intrinsic value of the share price.

Without deferring from the topic any longer, the PE Ratio should coincide with the growth rate of the company. If the company is growing by 10% its PE Ratio should be about 10. If a company is growing at 20% but its PE Ratio is 10, then that could be a bargain position for the investor. Likewise, if the company is growing at 5% but its PE Ratio is 10, then the company might be overpriced. There are many ways to measure the growth of a company, but the one I personally prefer is the growth in Sales for this particular circumstance.

Sometimes its useful to take the adjusted earnings per share in the PE Ratio instead of the earnings per share as indicated in the Statement of Financial Performance or Income Statement or Profit & Loss Statement. The adjusted word just means that any one-off expenses, extraordinary income is removed to just take into account the usual, normal course of operation revenue and expenses that the business occurs. The adjusted PE Ratio then more or less reflects the true PE Ratio of the business.

By textbooks standard, a PE Ratio of less than 10 is considered a bargain. A PE Ratio of 10-15 is considered cheap, a PE Ratio of 15-20 is medium risk and finally a PE Ratio of more than 20 is considered risky/expensive. However, textbooks' PE Ratio do not always reflect the true worth of a company. There are value businesses which have been priced at PE Ratios of more than 20, yet have done really well over time. What truly matters is not paying more than the intrinsic value of a company and buying a company with a sustainable competitive advantage. For example, Perpetual(Australia's oldest fund-managing company) was trading at a PE Ratio of 24 a few years ago, yet until now, its earnings have more than doubled and its share price rallied much higher.

So the conclusion about PE Ratios is that it is a good starter to measure the possible worth of a company, and is worth taking into account, it being one of the oldest yet valuable form of measure of a company's worth. During the tech boom, there were companies trading at a PE Ratio of 500! How long would you have to wait to regain your capital assuming the earnings dont change per year?