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Any conversation about purchasing shares will eventually bring up the price-to-earnings ratio, or P/E ratio. Therefore, what is it and what can it tell us about certain shares, their rivals, and the markets they operate in?
Keep in mind that you run the risk of losing money when you invest. Investment returns can be both positive and negative, and you could not get your money back. You should get financial counsel if you are unclear of the best decision for your specific situation.
What is a P/E ratio?
The P/E ratio is derived by dividing a company’s share price by its profits (net profit) per share. (EPS).
It quantifies the premium that investors are prepared to pay over a company’s present earnings, which reflects the premium that investors are willing to pay over a company’s expected future earnings growth.
Technology companies, meanwhile, have faced major valuation downgrades as US stock markets reach bear market territory, with Tesla currently trading on a P/E ratio of 54. The parent company of Facebook, Meta, too had a similar fate, with its P/E ratio falling from 18 to 9 last year.
Delving deeper
There are two distinct P/E ratio types:
- The “trailing” or “historic” P/E ratio is based on actual EPS for the previous financial year or the previous twelve months (also known as trailing 12 month earnings).
- The predicted EPS for the following fiscal year supplied by the company and/or analysts form the basis of the forward P/E ratio.
Or, to put it another way, it would require investors to generate enough money over the course of five years to recoup their initial investment. Investor expectations for minimal earnings growth are implied by this.
A low P/E ratio may signify that investors think there is a high danger that the company won’t reach profits projections. P/E ratios may represent investors’ perceptions of the risk associated with investing in the company.
How to use P/E ratios to value shares
A P/E ratio is relative, which means that it is only useful when compared to the company’s (publicly listed) rivals and the larger stock market.
Let’s examine the various P/E ratios for “growth” and “value” stocks.
- What are typical P/E ratios for growth shares?
Investors are willing to pay a premium price for these shares in relation to their existing earnings because they anticipate a strong rate of earnings growth.
Four of the biggest US technology businesses currently have the following trailing P/E ratios:
| Share/index | P/E ratio | Forecast EPS growth (per annum) |
|---|---|---|
| Netflix | 31 | 22% |
| Apple | 27 | 6% |
| Meta (Facebook) | 24 | 19% |
| Alphabet | 23 | 20% |
| Nasdaq 100 | 25 | n/a |
With a P/E ratio of 31, Netflix has the highest ratio among the firms in this group and the Nasdaq 100. However, although selling on significantly lower P/E ratios than Meta and Alphabet, its projected earnings growth is comparable to those companies’.
The company’s EPS also decreased by more than 11% in 2022, which raises the historic P/E ratio; however, the forecasted profits recovery will result in a decline in the forward P/E ratio, lowering it.
The company’s share price and, consequently, the P/E ratio have suffered because its earnings were below forecasts and because of worries about macroeconomic headwinds.
2. What are typical P/E ratios for ‘value’ shares?
In contrast to the growth shares that predominate on the Nasdaq, the FTSE has a higher percentage of value shares. Many of the FTSE firms work in established sectors including mining, energy, finance, and industrial items.
Observe the trailing P/E ratios of a few FTSE 100 companies:
| Share/index | P/E ratio | Forecast EPS growth (per annum) |
|---|---|---|
| Tesco | 21 | 5% |
| Sainsbury’s | 11 | -1% |
| HSBC | 9 | 22% |
| NatWest | 8 | 10% |
| FTSE 100 | 14 | n/a |
There is less of an association between the P/E ratio and earnings growth, despite expected earnings growth being marginally lower than the group of four US equities we examined.
The high dividend yield of these FTSE businesses, which ranges from 4 to 5%, is a measure of the income owners will receive relative to the present share price. If demand for the share increases as a result of investors seeking for income, this could potentially have a favourable effect on the share price.
Tesco has a much bigger market share than Sainsbury’s, but selling at a somewhat lower dividend yield, which might assist it to continue making money despite the present cost-of-living crunch. Due of Tesco’s superior fundamentals over Sainsbury’s, investors may be tempted to pay more for Tesco stock.
Why have P/E ratios fallen recently?
Share prices and P/E ratios are significantly influenced by investor sentiment. Over the past 18 months, concerns about high inflation, increasing interest rates, and geopolitical unpredictability have had a negative impact on valuations.
But throughout the same time span, the P/E ratio of the FTSE 100 has remained stable at roughly 13 to 15, largely because it has a bigger percentage of value companies. Investors frequently convert from growth to value shares during a recession because the latter are more resilient due to their more defensive attributes.
What are the limitations of the P/E ratio?
When considering an investment, investors should also take other financial indicators like profit margin, dividend yield, cash flow, and net debt into account.
It’s also important to consider the following P/E ratio restrictions:
- The P/E ratio can be significantly impacted by various EPS measurements, such as trailing or forward EPS, or adjusted EPS to take one-off things out. Additionally, EPS is a snapshot at a specific moment and might not be an accurate representation of average earnings.
- The funding structure of a corporation is not sufficiently reflected by the EPS. Due to interest payments, a business with more debt could have lower EPS. If the money is put into the business, however, debt may actually increase future earnings growth.
- Forward P/E ratios are less reliable if a firm doesn’t achieve its EPS projections.
Should you buy shares with a low P/E ratio?
It’s easy to consider businesses with a high P/E ratio to be “overvalued.” However, if that business generates large earnings growth, which raises the share price, then its greater valuation is justified.
Similar to this, a business with a low P/E ratio may have potential share price appreciation if it has faster-than-anticipated earnings growth. Or its dividend yield may draw in investors, driving up the price of the stock as a result of the increased demand for dividend-paying stocks.
The company may, however, be selling at a low P/E ratio for good reason, such as because it is experiencing financial difficulties or is in a sector that is cyclical and is going to experience a downturn.