P/E ratios: looking at share prices and earnings

Imagine you want to buy a kilogram of plums at your local weekly market. You're in luck: there is a large selection of plums to choose from, as several market stalls are selling your favorite variety. So how do you choose which to buy? The price, or more specifically, the price per kilogram, will no doubt play an important role, as it enables you to make a comparison between the different suppliers.

Using the P/E ratio to compare share prices

Anyone investing in equities faces a similar question: which stocks are attractively priced, and which are overpriced? Fortunately, equities also have a price tag of sorts that makes it possible to compare the share prices of different companies. This is the so-called price-earnings ratio (P/E ratio). For many investors, the P/E ratio is one of the most important indicators for assessing a stock's value for money and deciding whether to buy, hold or sell it.

This ratio is usually calculated by dividing the company's current stock market price by the expected future earnings per share. Put simply, when comparing two companies, the one with the lower P/E ratio is more attractive to buyers. For example: companies A and B have the same share price of 20 euro. The expected annual earnings are 2 euro per share for company A, resulting in a P/E ratio of 10. Company B is expected to have annual earnings of 2.50 euro, which corresponds to a P/E ratio of 8. In other words: at the same stock market price, share A costs 10 annual earnings, while share B only costs 8 annual earnings. B thus appears to be more attractive, at least at first glance.

How reliable is the P/E ratio?

Is it really that simple? No, unfortunately not. A company can influence its reported earnings, and thus also the P/E ratio, relatively easily through its accounting practices. In the example above, the difference in earnings may simply be attributable to the application of different accounting principles, particularly with respect to depreciation and amortization. To get a better picture, investors can therefore look at the share price relative to cash flow (which provides greater insights), or in other words, earnings plus depreciation and amortization. Even then, however, the question of future earnings and cash flows remains. To determine these, numerous assumptions have to be made, any one of which may turn out to be wrong. Calculating the correct P/E ratio is therefore not as simple as one might initially think.

In addition, the P/E ratio should always be viewed in a broader context. According to a rule of thumb, stocks with a P/E ratio below 12 are considered cheap, while those with a P/E ratio above 20 are considered expensive. However, relying blindly on this rule of thumb is dangerous because P/E ratios are impacted by other factors. Three thereof are explained below:

The industry factor

Companies in different industries usually have different P/E ratios. One reason for this is industry-related differences in earnings growth. When companies report strong earnings growth, investors tend to be more willing to accept a higher share price or a higher P/E ratio. The reverse is true for risk: the riskier a company and its earnings are considered to be, the lower the share price and thus the P/E ratio will generally be. It therefore makes little sense to compare the high P/E ratio of a rapidly growing technology company with the much lower P/E ratio of an established, conservative insurance company and conclude that the insurance company is the better investment. It makes more sense to use the P/E ratio to compare companies in the same industry, for example different insurance companies.

The interest rate factor

Equities are in competition with other investment opportunities, especially bonds. If bond interest rates rise, for example because central banks increase key rates, equities become less attractive in relative terms. Investors will increasingly sell their stocks and buy bonds. As a result, share prices and the P/E ratio will tend to fall. Since interest rates usually equate to costs from a company's perspective and can therefore put pressure on earnings, the interest rate effect becomes even stronger. Above all, however, higher interest rates mean that future earnings are discounted at the higher interest rate and are therefore worth less in the present. When assessing whether a company is attractive in terms of its P/E ratio, the current interest rate level and expected interest rate developments must therefore always be taken into account.

The inflation factor

If inflation rises, stock prices usually fall and with them, the P/E ratio. This is because inflation usually leads to higher nominal interest rates. In addition, profit margins in many industries decrease when inflation occurs, at least in the short term, because their expenses, for example for wages, raw materials or energy, rise and they can usually only pass those higher costs on to consumers with a delay. But deflation is also bad for companies' profits, because their customers speculate that prices will go even lower and thus postpone planned purchases. In addition, the price of companies' products in the market continues to fall while they are still processing their expensively purchased raw materials. Due to these effects, higher inflation and deflation also mean that estimates of future earnings are subject to greater uncertainty, which puts downward pressure on share prices, and thus the P/E ratio, due to the corresponding risk discount.

Conclusion: Look closely

The P/E ratio is one of the most widely used ratios, not least because it allows for a simple, clear and easy-to-understand assessment of share prices. But the same applies here as it does for the plums at the market: look closely, smell the fruit, test its ripeness and compare what is on offer at the various market stalls before opting for a supposed bargain that turns out to be a flop.

Photos: market stall: iStock; P/E-ratio: Shutterstock