[quote]The P/E ratio
P/E stands price to earnings. You may have seen a comment like “Dodgy.com trades at a forward P/E of 10, making it look fully valued,” or “Techtastic has a trailing P/E of 30, which makes it look cheap in comparison with other companies in the sector.” But why is Dodgy.com considered “fully valued” and Techtastic thought to be “cheap”? And what is the difference between a forward and a trailing P/E?
The P/E is calculated as the company’s share price divided by its earnings per share (EPS). It can also be calculated as the company’s market value divided by its net profit (after tax but before dividends).
EPS is calculated as net profit (again, after tax but before dividends) divided by the number of shares the company has.
Let’s take an example, which should make this a little clearer. EPIC is a relatively new company but it is already profitable. Last year it made the conveniently round number of £1m in profit after tax. Even more conveniently it has 10m shares in issue on the stock market. So its EPS can be calculated as:
£1m/10m = 0.10 or 10p
EPIC’s current share price is 300p, so the P/E is:
300p/10p = 30
This is a trailing or historical P/E because it is calculated on past profits. One way of looking at it is that a P/E of 30 implies that, at the current level of profits, it will take 30 years for you to get your money back. Yikes!
You can also calculate P/Es based on earnings estimates for the current year. The stock market is forward looking so many people prefer to use forecast (or prospective) P/Es rather than historical ones. So if EPIC was predicted to make £1.5m in profits next year that would make its forward EPS 15p and its forward P/E 20.
However, while historical numbers cannot change, brokers’ profit forecasts often do over the course of a year as the company releases new information on how it is trading. For this reason many people use these two P/E measures in conjunction to get a more complete picture.
But do these figures mean EPIC is incredibly cheap, wildly overvalued or somewhere inbetween? Many people often make a snap judgment about a company’s valuation based on its P/E. Usually they compare a company’s P/E with the overall market or with others in its industry.
Although this can be a useful starting point unfortunately you need to look a little deeper. That’s because the year you’re looking at in order to calculate the P/E may not be a good indicator of what level of profits will be generated in the future. In our example, perhaps the £1m in profit was mostly due to a one-off contract that won’t be repeated. Or perhaps it was just the initial stage of a large deal expected to generate much higher profits for many years to come. If you’re comparing a company’s P/E against the market or its industry then you also need to consider how much their earnings will grow over the coming years.
The point is that an investor needs a lot more information than the P/E number alone to attempt to put a value onto the company. That is because the P/E ratio, like many valuation measures, is a one-dimensional number. In order to get a more complete picture of whether a company is cheap or expensive you need to look at several valuation measures in conjunction.[/quote]
