Price earnings ratio (P/E)
This is the quotient that represents the relationship between the market price per share to earnings per share of the business
Computation of P/E Ratio
Where;
MPS is market price per share
EPS is earnings per share
Illustration & Examples
Illustration one
Bank of the Commons (BOC) provided you with the following information at the end of the year 2018
- Stock Price = $32.12
- EPS = $2.52
Required
Determine the P/E Ratio
Solution
Steps of Computing P/E Ratio
STEP 1: Identify the current market price per common stock or ordinary shares. If the business has been in existence, determine the average price
STEP 2: Compute EPS. If not given
Consider the profit after tax and preference dividends
STEP 3: Use the formula of P/E to determine the P/E ratio
Example
Horizon Net Ltd. Current market price of its common stock is $400 and the company’s earnings per share are $40. Then Price-to-earnings Ratio of Horizon Net Ltd. will be calculated as follows:
P/E = 400 /40 = $10
Interpretation is that the market value of the company is ten times better than the value invested by the owners.
Market Interpretation of P/E Ratio
1. It is a metric to compare the market performance of the business. So the question is, what market implication is carried by P/E ratio?
2. It shows the market value of the business at some point in time which is also compared to the value of the investor he/she has put in the same business
3. It shows the market competitive edge of the business. With a high P/E ratio, it shows that the company is effectively competing with other firms in the market
4. It shows the net worth of the shareholders-with P/E ratio, the higher it is the better the market value of the firm and the higher the net worth associated to the owners in case they sell the business
5. It shows over or under valuation-the P/E ratio gives an hind of whether the market has overvalued or undervalued the firm
Importance of P/E Ratio
1. Assess firm relevance to the market-the P/E guide in knowing whether the business is meting the needs of the market. For if poor quality services are being offered, this will be reflected in the market price of the firm
2. Management strategy gauging-management can use the metric to assess how strategic is their approach in the market
3. Future planning-P/E ratio is a yardstick to guide the management to plan for the future
4. Resource allocation-used to allocate resources in a better manner. For instance an high P/E ratio is an indicator of fully utilized resources
Why Know the P/E of a Business?
1.Helps the investor to know at what point he/she can invest in an organization or even the time of disinvesting
2. One can assess the market share of the business at a glance
3. P/E is good for benchmarking of the firm performance to that of the industry
4. P/E can guide in predicting the future growth of a single firm
Applicability of P/E in Investment Decision Making
1. Sale or purchase of a business-use P/E of the firm as compared to the peers to set selling price of your business
2. Assess the inflationary level in the economy-before investing, one can rely on the P/E ratio to assess if the prices are high or normal
3. Reflection of future growth-P/E is a spring board for firms with a potential of future growth
4. P/E ratio represents the growth lifecycle of the business such that at low or development stage, the P/E ratio is low as compared to growth stage hence one can do good timing on when to invest.
Advantages of P/E Ratio
1. Commonly applied in the market analysis: The P/E ratio is commonly relied upon stock market data analysis and even for financial stocks like financial institutions.
2. Simple to compute and interpret: P/E is very easy to determine.
3. Help in determining the purchase price of a firm: during a purchase of a business, an investor can know how much to pay through P/E ratio.
4. Help in determining the selling price of a firm: during a disposal of a business, an investor can know how much to receive through P/E ratio.
4. Determine growth trend potentials: PE ratios help investors to determine the company’s growth potential before they invest. By checking several past period P/E ratio trends, it is possible to tell the extent of growth the firm can reach
5. Compare firms in the same sector or industry: PE is used to compare and value businesses’ stocks with one another making it a useful analytical tool.
6. Make quick decisions: Although the P/E ratio evaluates the worthiness of the company, it can be used to make quick decisions on whether to invest or not in a firm in a particular industry. The potential investor need to compare the P/E ratio of one industry to that of another and decide rationally
7. Assessing over/undervaluation of stocks: P/E is a good benchmarking metric for determining whether the stock is overvalued or undervalued.
Disadvantages of P/E ratio
1. Does not consider accounting policies: P/E ratio is a market based metric and may be incomparable with Accounting principles and conventions.
2. Firm performance misrepresentation: the market price of stocks may also be determined by uncontrollable forces referred to as macroeconomic factors such as inflation. If there is high inflation, the prices go up and P/E ratio also increase and this does not represent better performance.
3. Misleading information: P/E can misinform firms operating on leverage. The inflated earnings through the sale of corporate assets at an inflationary price can lead to abnormal earnings resulting to unrealistic and unattainable P/E ratio.
4. Adoption of wrong decisions and strategies for future development: Due to inflated P/E ratio, it can cause confusion to the management leading to the wrong strategy especially when the high P/E ratio is due to inflation.
5. Not appropriate to appraise loss making department or business: Companies making losses cannot use the PE ratio since it can’t regulate losses at the early phases of business growth.
6. Use of Historical earnings data: P/E earnings are based on historical performance of the business and this may not be a good springboard to forecast the future results for the world is very much dynamic.
7. High probability of P/E value manipulations by management: Unnecessary overpricing of P/E ratio may mislead potential investors which may make them lose their income in the wrong investment projects.
Factors Affecting P/E of a Business
1. Past P/E ratios. Present or current P/E ratio is a derivative of earnings in the previous periods. Such that if there was low P/E ratios experienced, then the current P/E ratio will be low
2. Inflation rate-this is increase in general prices of the goods and services in the economy
3. Interest rates-refers to lending and borrowing rates in the financial markets and the money markets
4. Exchange rates-this is the price of a currency expressed in terms of another
5. Growth stage of a company
6. Level of debt/equity ratio-firms with greater share of debt tend to have a lower P/E
7. Dividend payout ratio-A company that tends to pay more dividend to the shareholders, tend to have a higher P/E
8. Expected growth rate of earnings of a business. P/E ratios can change fundamentally and abruptly because of change in the in earnings in the future.
9. Nature of industry-industries which are dynamic in growth will portray improved P/E ratios for firms operating under such an industry.
