P/E Ratio



The P/E Ratio is one of the most widely recognized fundamental indicators, and, one of the easiest to calculate. The P/E ratio stands for the price of the share compared to the earnings per share (EPS). Last week we discussed the EPS. Basically, the EPS is the amount of profit the company makes divided by the number of shares issued.

By comparing the price of the share to the earnings per share, we can gauge whether or not the share price is undervalued, fairly valued or overvalued. If the price of the share is very high, compared to the earnings, then the P/E ratio will be very high too. High P/E ratios identify shares that may be overvalued and hence, it may be sound to sell the share.

A company with a low share price, but high earnings, will have a very low P/E ratio. This low ratio identifies to the investor that the share price is undervalued, and could represent a buying opportunity.

For example, let's say that the share price for our imaginary company, XYZ ltd, is $1.00. The EPS for the company is $0.10. Our calculation would be as follows:

P/E Ratio = Price of the share

Earnings per share

10 = $1.00 / $0.10

Therefore, the P/E ratio for XYZ ltd is 10. Now what exactly does this mean?

Well, we can do a variety of things with the P/E ratio. We can compare the P/E ratio of XYZ with previous P/E ratios for XYZ. If we notice a trend of increasing P/E ratios, then the share price may be reaching an overvalued situation. If the trend has been of decreasing P/E ratios, then perhaps the company is currently unpopular with investors, but may be a good buy.

Alternatively, we can compare the P/E ratios of other companies in the same industry and sector. For example, if we notice that XYZ's competitors have much higher P/E ratios, then perhaps XYZ represents a good buy. If XYZ's P/E ratio is substantially higher than it's competitors, then perhaps it is approaching it's peak in price. As you can see, the P/E ratio can be rather vague. The most sensible use of the P/E ratio, in my opinion, is to use it when calculating the PEG ratio.

PEG Ratio

The PEG ratio is one of the most powerful indicators. Every famous successful investor, such as Warren Buffett, and Peter Lynch use the PEG ratio as one of their principle leading indicators when assessing a potential investment.

The PEG ratio compares the P/E of a share with it's earnings growth rate. Hence, the PEG ratio stands for Price of the share, compared to the Earnings of the share, compared to the earnings Growth rate of the share.

Let's consider XYZ again. It has a P/E ratio of 10, and an earnings growth rate of 15. This means that the earnings (profits) are growing at 15% per annum.

PEG ratio = (Price of the share/Earnings per share)

Earnings Growth rate

0.66 = 10/ 15

A PEG ratio less than 1 indicates that the share price is undervalued. The price of the share is low compared to its earnings and to its growth rate. If the growth continues, then the share will continue to produce excellent returns. Other investors will eventually recognize this and will invest in the company. The increased demand will increase the share price.

A PEG ratio greater than 1 indicates that the share price is overvalued. Be sure to incorporate the PEG ratio in you analysis techniques. This simple, yet effective indicator will help you evaluate your investments regardless of which international market you choose to trade.