Is using the P/E ratio sufficient?

Is using the P/E ratio sufficient?

NAV TL;DR

If you don’t have time to read through the whole article, you can check out our short version below.

  • The P/E ratio measures a company’s stock price relative to its earnings and be calculated based on past or projected earnings
  • The P/E ratio is best used to compare companies of similar size within the same sector
  • Do not rely on a single metric to evaluate a stock but a combination of them so that you can make a more accurate assessment.

Investing in stocks is one of the main ways most retail investors adopt to grow their savings. You stand to benefit from capital appreciation of a stock and/or through dividends that they pay over time. If done well, returns are potentially higher than if your money was left idle in the bank.

That said, it does come with risks, especially if you are careless in stock selection. This process of putting together a diversified basket of stocks can be daunting for many first timers as many different valuation methods can be used before arriving at an investment decision.

One of the common ways to value a company is by using the price-to-earnings ratio (P/E ratio). It measures a company’s stock price relative to its earnings and is one of the most common ways to evaluate a company before making an investment decision.

Simply put, the P/E ratio is the price investors are willing to pay for $1 of a company’s profit. It is calculated by taking the current share price divided by earnings per share (EPS).

The P/E ratio can be measured as a trailing (it takes into account recent EPS) or forward (based on forecasted EPS) ratio.

For example, if Stock Z is trading at $10 and EPS for the most recent 12-month period is $0.50, then the trailing P/E ratio of Stock Z is 20. If we assume profits stay constant, it would take the investor 20 years to regain its share price.

The P/E ratio comes in handy:

  • as a gauge for the price direction of a stock
  • as a comparison of how cheap/expensive a stock is relative to its past or peers
  • in determining whether a stock is trading on an investment or speculative basis
  • at helping you avoid getting swept away in bubbles or panic selling.

Comparing P/E Ratios

Is using the P/E ratio sufficient?

A high P/E ratio might indicate a stock’s price is high relative to earnings and also suggests that a stock is overvalued. However, this might not make a stock a bad buy.

If investors expect both revenue and profits of Company A whose shares trade at a high P/E ratio of 50 to greatly outperform Company B with a P/E ratio of 25, the former might not be overpriced. This might also be true if Company A has a history of showing increasing earnings each quarter or year.

Given investors believe Company A will keep to this trend, they are willing to pay a premium for less risk, and hence a higher stock price and P/E ratio.

On the other hand, a low P/E ratio shows that a stock’s price is low relative to its earnings and could be undervalued. Investors can take the opportunity to pick up undervalued stocks and can profit when the price of the stock rises in the future. But you should note that a stock with a low P/E ratio does not always represent a value buy. Low P/E ratios could reflect a company with little potential for further growth.

That said, you should bear in mind that using the absolute value of this ratio does not paint the full picture. There are other factors to take note of when making comparisons between two companies based on P/E ratio.

The average P/E ratios of different sectors (i.e Financial, Telecommunications and Healthcare) vary. For example, Financials like banks may trade at an average P/E ratio of 12, while Healthcare companies trade at a higher average P/E ratio of 26.

This means you should compare P/E ratios between companies operating in the same sector to get a better picture of whether a stock is overvalued or undervalued.

5 other valuation metrics

Most people won’t buy a handphone just by picking their favourite colour.

It is the same in investing. You should not use a single metric as it will not provide you with enough information to arrive at an investment decision. Like other financial ratios, there are limitations to using only the P/E ratio.

Here are other metrics you might want to use when evaluating a stock.

1. EV/EBITDA

The enterprise value to earnings before interest, tax, depreciation and amortisation ratio (EV/EBITDA) is a measure used to determine the value of a company. EV/EBITDA is calculated by taking the market capitalisation (price of share multiplied by outstanding shares) of a company plus debt minus cash.

EV/EBITDA is usually used in tandem with the P/E ratio to valuate a company. A low EV/EBITDA value might point to a stock being undervalued while a high EV/EBITDA could suggest a stock is overvalued.

That said, you should take note that EV/EBITDA tends to be larger for high growth sectors or companies while they are lower for those operating is stable growth sectors.

2. Price-to-earnings-to-growth (PEG) ratio

Is using the P/E ratio sufficient?

The PEG ratio is an improvement on the P/E ratio as it considers earnings growth of a company. It is calculated by taking the P/E ratio and dividing it by the growth rate of a company’s earnings over a specified period. This allows investors to take into account both past earnings while providing a gauge for future earnings.

Generally, if the PEG ratio is more than 1.0, a stock is said to be overvalued while a value of less than 1.0 suggests a company could be undervalued.

3. Price-to-Book (P/B) Ratio

The P/B ratio, which measures the market value of a company relative to its book value, is another commonly used metric for evaluating stocks. It is calculated by dividing a company's price per share by its book value per share.

Theoretically, if a stock has a P/B ratio of 1.0, it is “fairly valued”. In other words, when all assets in a company are liquidated and debts are paid, the price of the stock will be same as its book value.

The P/BV ratio is handy when used for companies with high tangible assets (physical assets) but is not as reliable in evaluating companies with more intangible assets like technology firms.

4. Return on equity (ROE)

Is using the P/E ratio sufficient?

A profitability measure, ROE shows how effectively a company utilizes its assets to generate profits. Expressed as a percentage, it is calculated by dividing net income by shareholders' equity. The higher the ROE, the better.

In general, you should compare ROE of companies within the same sector. If a company has a better ROE than the average of its peers, it would be safe to say its management is better than most others at using assets to generate profits.

ROE is often used with the P/B ratio. A stock is said to be overvalued when ROE is low but the P/B ratio is high. The reverse holds for an undervalued stock.

5. Debt-to-Equity Ratio

The debt-to-equity ratio how much a company is leveraged. It shows how much a company uses debt and its own funds to finance its operations. It is calculated by dividing a company’s total liabilities by total shareholder equity. The lower the figure, the better. That said, like other financial ratios, it should not be looked at in isolation.

Higher debt levels are not necessarily a bad thing, especially if the company is able to produce returns higher than the interest charged for its debts. A company with a lower debt-to-equity ratio than its peers has more avenue to raise funds for expansion through borrowing.

In Summary

The P/E ratio, along with the other financial ratios listed above, can help you better understand the stocks you are interested in. Do note that this list is not exhaustive and serve as a starting point.

It is important not to rely solely on one metric when making an investment decision. It is best to take note of several metrics to get a fuller picture of a state of business and its prospects.

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