Explaining the price to earnings ratio – Part 2

What does the PE Ratio tell investors?

Fundamentally, the PE ratio tells us how many years of earnings we are paying for when we buy a stock at a certain price (if nothing changes). It tells us how many years it would take the company, in which we have invested, to earn the amount we invested, if nothing changes. 

As an example, let us say we pay $10 for a stock with full-year earnings of $2 per share. All things being equal, after holding the stock for one year, the company earns $2 per share; after year two, the total earnings are $4.00; after year three, the total earnings are $6; after year four, total earnings are $8; and at the end of year five, the total earnings are $10. Thus, within five years the company has earned back all the money that we, the investors, had invested in it. In other words, by paying $10 per share initially, we paid for five years’ worth of earnings upfront. This is also one of the reasons why it became ‘common wisdom’ to buy stocks with lower PE ratios. Let us now look at why this might not always be the wisest decision.

PE ratios can be misleading to the Investor

As I said earlier, it is generally accepted that a low PE Ratio is favourable and a high PE ratio is unfavourable but this can be very misleading. Let us look at the performance of companies X and Y, both of which are in the technology sector. Company X has a market cap of $50 billion and manufactures computers and hand-held devices. Its stock sells for $100 per share and it reported an EPS of $12.00 per share in their last annual report. The EPS was down from $15.00 the year before. I will also add that analysts expect that Company X will report an EPS of $9.00 per share for the current year. Company X, therefore, has a trailing PE of 8.33X earnings and a forward PE of 11X earnings. Work these out and verify them.

Conversely, Company Y has a market cap of $40 Billion. The company is a software company and is the owner of a social media application that has gone viral within the last six months. Company Y stock sells for the same $100 per share and the company reported an EPS of $3 per share in their last 10K filing. Based on the number of downloads for the company’s new app, and the rate of growth in the download numbers, Analysts expect that the company will report EPS of $5.00 for the current financial year. Company Y, therefore, has a trailing PE of 33.33 and a forward PE of 20X earnings at the current price.

Analysts recommend that investors buy Company Y and sell Company X, but why? Why is Company Y a better a buy than Company X despite its forward PE ratio being almost twice as high and its trailing PE, almost 4X higher than that of Company Y. The answer lies in operations and is more qualitative than quantitative.

Company X is a larger company but is experiencing a decline in its profitability. It is possible that low-cost manufacturers have entered the market and are offering similar products at a lower price than Company X, making it harder for them to compete. Due to the nature of Company X’s business, they will have to spend a lot more money if they want to expand or spend more on marketing. This could further erode the company’s profitability.  On the other hand, Company Y’s profitability is growing. It just launched a new app that has gone viral. Advertisers will be more attracted to the company in order to be able to show ads to the growing number of users of Company Y’s app. Furthermore, Company Y might not have to spend as much in order to increase profitability. These factors make Company Y a more compelling offer to investors as they are more likely to see an increase in the value of their portfolios if they invest in Company Y than if they were to invest in Company X.

Key Takeaways

The PE ratio is calculated by dividing a company’s stock price by its earnings per share or EPS. The PE ratio is a relative valuation method. It is used to compare other stocks in the same sector as well as to the market as a whole. The PE ratio tells investors how many years it would take for a company to earn back the amount paid for its stock. Investors should be careful to not rely only on the PE ratio, since it can be misleading at times.

A company with a low PE ratio is not necessarily a bargain and could very well be more overvalued compared to a company with a larger PE ratio.

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