What is Price to Earnings Ratio (PER or P/E)?
Of all the many useful statistics when it comes to analyzing shares, the Price to Earnings Ratio (also known as PER or P/E) is perhaps the most important. It provides a basis for valuing stocks and shares and deciding if they offer good value, are fairly priced or over priced.
In its essence the Price to Earnings Ratio is a measurement of how much the share costs (the price) in proportion to the net profit per share the company earns in a year. So a PER of 15 would mean you are paying 15 times the earnings per share that the company achieves. This would mean that if the earnings remained the same every year at a PER of 15 it would take 15 years for the company to earn as much per share as you have paid for it.
However as no company has the same earnings year on year, the Price to Earnings Ratio changes each year. The share price also varies constantly, so PER is a constantly changing ratio especially from year to year.
When quoting a current Price to Earnings Ratio there are usually two main methods which have significant difference. First up is the Historic P/E. This is today’s share price vs the last financial year’s Earnings Per Share figure. Secondly you can use the Rolling Forecast P/E which uses the next two years averaged EPS estimates vs todays share price.
For example, lets take Skyepharma – a company we have just this week invested in. In their 2013 financial year, which is the most recent they have posted, their EPS was 1.37p. Their share price is currently £3.305, so their historic P/E for last year is 3.305/.0137 = 241 which looks very expensive. However the rolling forecast P/E is much nicer, because this is a high growth company with forecast EPS (earnings per share) of 16.1p in 2014 and 27.5p in 2015. Using today’s £3.305 share price, this gives a forecast P/E of 20.5 for 2014 and 12 for 2015.
In our opinion the forecast P/E is more useful since we’re more interested in what the company is going to achieve and not the past performance. Market estimates tend to be pretty accurate as well, so most of the time you should be able to rely fairly well on them. Of course sometimes companies issue profit warnings or guidance that they wont meet expectations – but they are legally obliged to do this as soon as they are aware of it so if something does go wrong you should know pretty soon.
So what is a fair Price to Earnings Ratio to pay?
There’s no one size fits all answer to this, but we typically aim for between 8 and 15 as being good value (on a forward basis). Sometimes we’ll pay more for a growth company who we think will quickly bring that ratio down in future years, or if the company has a great dividend. We dont like paying much more than 20 though even for growth shares.
Others arent so cautious with high P/E shares and sometimes will pay hundreds of times the EPS. Just Eat (LSE: JE.) for instance, which launched on the stock exchange a few months ago, is trading for 209 times its 2013 EPS and 89 times its 2014 forecast EPS and the price is still trending upwards. You can still make money on high P/E stocks, but they inherently carry more risk and downside. ASOS is a great example of a high P/E share gone wrong – in March it was trading at £70 per share (a historic P/E of 141) but now only six months later has fallen to £19.85 per share for a more reasonable P/E (h) of 41. If you are going to trade a high PER stock, then it pays to sell up once it starts trending downwards as the losses can soon mount up and that hefty price to earnings ratio that has built up has given it a long way to fall.
Is a Price to Earnings Ratio of less than 10 a sure sign to buy a stock?
Not always, sometimes shares with very low P/E ratios are what we call ‘value traps’ and are cheap for a reason. Perhaps there’s a big question mark over the company’s head. A good example right now is Quindell. We actually like that stock but there’s a number of high profile sources (including Gotham City Research and Tom Winnifrith of Share Prophets) who are asking serious questions about their accounting procedures and claiming that they are fabricating their profits. Quindell is therefore 76% down on its 52 week highest share price at the time of writing and has a forecast PER of 2.1! A crazy valuation for a company that has forecast Earnings Per Share Growth of 52%. However, as good a value as it is, there’s no guarantee that it will bounce back from recent share price pressure, so it remains a potential value trap. If you find a share with a PER too good to be true, always do your research and check there isnt a nasty reason why it’s so cheap.
Some Examples of Low Price to Earnings Ratio (forecast) Shares we like at present:
Avation (AVAP) 6.5
Plus 500 (PLUS) 8.16
Brit (BRIT) 8.52
GVC Holdings (GVC) 8.7 (with a 7%+ dividend on top!)
Royal Dutch Shell (RDSB) 9.81
City of London Investment Group (CLIG) 11.1 (another with a 7%+ dividend)
Santander (BNC) 12.6 (with 6%+ dividend)
Renew Holdings (RNWH) 13.3
What is the Price to Earnings Ratio – By Loco Investing
Disclosure: We hold investments at the time of writing in all of the companies discussed except Just Eat and ASOS.