All investors hope to peer into a crystal ball to know whether a company’s stock is worth investing in based on the current market price. Unfortunately, there is no crystal ball for market performance.
One of the basic valuation metrics of a stock is Price to Earnings Ratio (PE Ratio), which was made popular by the late Benjamin Graham, also known as the Father of Value Investing .
Basically, the PE Ratio is used to value a stock, whether it is undervalued or overvalued when compared to the same industry as a benchmark.
Let’s look at the formula of the PE Ratio:
PE Ratio = (Market Price)/(Earnings per Share)
There are two different perspectives to look at this valuation metric.
First Perspective: Number of years to recover one’s investment principal
In one way, the PE Ratio can be used as a reference to how many years it would take to recover one’s investment principal from earnings a company generates based on a full year or latest four quarters’ earnings.
For example, let’s say the market price of RHBCap is RM8.02, and its EPS for the Financial Year 2013 is 72.9sen. The PE Ratio is 11 times.
PE Ratio = 8.02/0.729 = 11x
Based on this example, for every share purchased, it would take you 11 years of cumulative earnings to equate to
the current stock price.
From this perspective, the lower the PE Ratio valuation, the shorter period of time for an investor to recover his/her investment principal, and thus the investment risk is lesser.
However, do consider the second perspective of this valuation metric.
Second Perspective: Reflecting the prospects of a company’s future earnings
In another way, the PE Ratio reflects the confidence level of the investors towards the company’s future earnings prospects.
From the second perspective, this financial ratio gives investors an idea of what the market is willing to pay. The higher the PE Ratio indicates the market has higher hope for the company’s future and thus bids up the price.
The growth in earnings will bring the PE Ratio back down to a lower level, and thus an investor will feel comfortable buying the stock even if it has a high PE Ratio.
Conversely, a low PE Ratio potentially shows the investors are lacking confidence and/or have a negative outlook about the company. Decrease in earnings will push the PE Ratio to a higher level.
Let’s look at the two different cases to explain the PE Ratio:
Example 1. Company A, Company B and Company C are operating the same type of business in the oil and gas industry. Their earnings, stock price and PE Ratio are summarised as follows: