The price earnings ratio, or the P/E ratio, is widely quoted by the investment community. It is also sometimes known as “earnings multiple” or “price multiple”.
Simplistically, it is arrived at by dividing the price of a share by the earnings per share, or EPS. For example, a Rs 200 share price divided by EPS of Rs 20 represents a PE ratio of 10. Theoretically, this means that if we were to buy this company today it would take 10 years to earn back our investment.
The P/E ratio tells us how much the market is willing to pay for a company’s earnings. A higher P/E ratio means that the market is more willing to pay for the earnings of the company and has high hopes for the future of the share. Conversely, a lower P/E ratio indicates that the market does not have much confidence in the future of the share.
There are plenty of issues with the PE ratio. One is that it does not account for any type of growth or the lack of it. Also, companies with major debt issues are obviously higher risk investments, but the P in the P/E ratio only considers the equity price and not the debt that the company has incurred.
Karl Siegling, portfolio manager at Cadence Capital, mentioned in Morningstar Australia some of the problems he associates with the P/E ratio. They are reproduced below.
1) The biggest and, by far, the most dangerous component of the P/E ratio is that the earnings are the accounting earnings as defined by the accounting standards for a particular country. These earnings are not the cash earnings of the business. In fact, many companies listed on the stock exchange earn no cash despite reporting profits.
2) A problem with the P/E assumption is that future earnings will be at least what they are currently. In the case of a company trading on a 10 times P/E ratio, we as investors are taking a chance that earnings will be at least what they are today for the next 10 years!
Working as an investor in the industry, it is quite clear that estimating the earnings of a company listed on the stock exchange for a year or two into the future is extremely difficult, let alone 10 years into the future.
3) Another problem with the P/E ratio is the idea that 10 times earnings is cheaper than 15 times earnings. The assumption that a company will earn its current earnings for the next 10 years and an investor will get their money back is, of course, theoretical.
A company's earnings may well go up significantly or down significantly over the next 10 years. It would follow that we as investors should prefer to own a company whose earnings go up significantly over the next 10 years rather down significantly. The P/E ratio has no way of telling us what will happen!
4) The P/E ratio tells the investor nothing about a company's balance sheet. It may be that a company trading on a 2 times P/E multiple is actually incredibly expensive since the company has a very large amount of current debt that it has no way of paying, and as a consequence, the company will be declared bankrupt in the current financial year.
We need only look back to the recent global financial crisis to find many examples of companies in exactly that situation.
5) The P/E ratio tells us nothing about the quality of a company's earnings. We may look at one company trading on 8 times earnings and declare it cheaper than a company trading on 16 times earnings.
We often hear conversations along these lines. However, upon closer inspection we discover that the company trading on 8 times earnings has just had a one-off profit never to be repeated and that the company on 16 times earnings has displayed 20% per annum earnings growth for the past 15 years.
It may well be that once these factors are taken into account, the company on a 16 times P/E multiple is actually a better investment than the company on 8 times.
The P/E ratio still has a place in valuing stocks, but investors need to use it in combination with other valuation methods, never as the sole reason for investing in a company.