How To Use Price To Earnings Ratio

Today we've prepared some slightly more technical material for you, starting a series of articles about fundamental analysis of markets and companies. In the first place, we will explain Price/Earnings ratio. It is hardly surprising that it is probably the most popular indicator, and yet so often misinterpreted.

Price/Earnings

By acquiring shares of a particular company, we become its shareholders. When its market value increases, share price also increases, and vice versa, when the company loses its value, its shares become cheaper. Buying shares of any company only makes sense if we assume that it will grow and will be increasing its profits. The company may pay dividends to its shareholders, but not if it decides to reinvest all earned money. In both cases, profits are strength of the company and the indicator discussed today refers to them.

P/E or Price/Earnings is nothing else than the current price of the company shares divided by its Earnings per Share (EPS). Therefore, if P/E is 10, it means that investors are willing to pay 10 USD for every 1 USD profit generated by the company. How on the P/E basis can we determine whether given share are currently undervalued (cheap) or overvalued (expensive)?

First of all, we can refer to market indices. For example, if we look at historical P/E for the S&P 500 index consisting of 500 largest companies listed on the New York Stock Exchange (see chart), we note that the price/earnings ratio ranged from 6 in 1948, up to 120 during the 2008 Great Financial Crisis. When we find an average, then it turns out that for the U.S. it is about 15 and this level is usually considered neutral in the United States. Accordingly, all companies with P/E lower than 15 are treated as undervalued and those with higher P/E are overvalued.

source: macrotrends.net

In fact, based on historical average, it is easy to refer to the entire market, but if we are going to invest in really cheap companies and not only limited to the U.S., we should adopt slightly more restrictive criteria. The following list shows P/E ranges that we use:

source: own elaboration

As you can see, we are a bit more strict, mainly because P/E for the U.S. market is one of the highest in the world. In addition, if we only take into account the last 10 or 20 years of the S&P 500, the average P/E would be even higher, which automatically raises our limits. This is best evidenced by the fact that once the Price/Earnings ratio at 20 was considered very high, and nowadays many people claim that this is a neutral level.

In the end, it is better to adopt more conservative criteria and not change them as speculative bubble develops.

P/E during the crash

Price to earnings ratio is a great tool that facilitates companies valuation, but also has drawbacks. First of all, it is very sensitive. Traditionally calculated P/E or Trailing P/E compares share prices to earnings per share earned in the last 12 months. Usually, companies' earnings are reported quarterly. Therefore, even a short-term drop in profits or incurring a loss significantly increases P/E value.

The graph below shows that the highest P/E for the S&P index did not occur during a speculative bubble growing period but immediately after its burst. This is because, during a crisis, share prices may drop by, for example, 50%, but at the same time company's earnings drop by 90%. Consequently, the P/E ratio is rapidly growing.

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