If you are new to investing in stocks, one of the frequently used investing terms you would soon get familiar with is the Price Earnings Ratio (aka P.E Ratio). P.E ratios are easily identifiable and can be located just besides share prices in the capital market segments of Newspapers such as Punch or in websites such as bloomberg.com, nse.com.ng, proshareng.com etc.
However, you can also calculate P.E Ratios yourself should you want to. The price earnings ratio is the ratio of the price of a stock to its earnings per share. It is simply calculated by dividing the current market price of a stock by its Trailing Twelve Months (TTM) earnings per share.
Let us use an example to demonstrate how this is calculated.
Assuming a company ABC Ltd has a share price of N10 and made a profit after tax of N20million in its most recently declared financial year (TTM). ABC Ltd also has total outstanding shares of Ten million units.
Step 1: Determine its earnings per share by dividing the total earnings of N20m by the outstanding shares of 10m. This produces an earnings per share of N2.
Step 2. Divide the price per share (10) by the earnings per share (N2) you get a P.E ratio of 5x
What does it mean?
The P.E ratio basically tells you how much premium or discount you are paying for a stock, to enable you lay claims to the earnings of a company. In the example above, at a price of N10 per share you are basically paying a premium of 5 times the earnings per share of N2 just to have a claim to the future earnings of the company. Companies can have P.E ratios of between 1x to 40x depending on how much premium the market is willing to pay for the stock. The lower the P.E ratio is, the cheaper the stock. A P.E ratio less than one is at a discount to earnings per share, whilst a P.E ratio of more than 1 is at a premium. It is uncommon to see a company with a P.E ratio that is less than 1. It usually indicates a company with a high negative reserve or one that is in distress.
Another Way to look at it
I like to view P.E ratios in an inverted way otherwise called the Earnings Yield. Using the example above, if you switch denominators the formula immediately changes to the earnings yield. Thus, a P.E ratio of 5x is also the same thing as an earnings yield of 20% (1/5). Looking at P.E ratio this way reveals an even far more compelling information. It means if you buy a company with a P.E ratio of 5x you are basically buying at a market return of 20%. That is the earnings the company made N2 divided by the price you paid for it N10 which is 20%. If 20% is a desired return for you, then a company’s earnings relative to that price will just be about appealing to you.
Why are P.E Ratios often high or low?
P.E ratios can be high when investors have a very bullish outlook of the company. High P.E stocks are mostly expected to grow their earnings per share quite fast they believe the price they are paying now will be justified in the future. High P.E ratios can also be an indication of a highly priced stocks particularly if the earnings growth does is not commensurate with the premium attached to it. Low P.E ratios on the other hand can be an indication that the stock is undervalued either because the market has completely overlooked it or its future prospects are understated. It could also be that the company’s earnings have been poor and the market expects no better. High P.E ratios are usually over 15X.
Forward P.E Ratios
Traditional P.E ratios utilize trailing earnings per share as a denominator. However, you can also use a forecasted earnings per share as a denominator rather than the traditional earnings per share. This result is called a Forecasted P.E ratio and is useful in determining the future value of a company relative to the price today. If forecasted earnings per share is high then your forward P.E ratios will be low making today’s price seem cheaper than it looks.
Is P.E Ratio the only way to determine whether to buy a stock?
Whilst P.E ratios are a very popular way in determining investment decisions in shares, it certainly isn’t the only one you should consider. As mentioned, P.E ratios is one of those metrics that you can use in determining how expensive or cheap a stock is. You should also look at the company’s fundamentals to find out if the business is a profitable one and can also guarantee you profits in the future if you were to hold for the long term
P.E Ratios in Nigeria
At the height of the stock market boom in Nigeria some stocks were selling for P.E ratios of 25x, 30x, 38x. Today the All Share Index averages at a P.E ratio of about 12x. A market with high average P.E ratio can therefore be an indication that the market is oversold and due for a bearish ride.