This page is quite old hence its rather spartan appearance.
Why not check out our Latest Stories page for our newest articles or search our site for anything.
MARKET COMMENT
By
The humble price to earnings ratio has its fair share of detractors. It remains the most popular way to assess how cheap or expensive a company's shares are, but it's a simplistic measure and you need to be cautious when using it. The p/e ratio measures the value of a company's shares in relation to its current profits. So a company valued at £500m which makes after tax profits of £50m is said to be on a p/e of 10. If it made profits of £25m then the p/e would be 20 and so on. So the higher the p/e, the more expensive a company's shares are thought to be. The danger with using the p/e lies in placing too much reliance on the current year's profits as a definitive measure of what profits a company will produce in the future. Investors need to ask themselves if the current level of profits is sustainable or if it has been boosted by short-term or one-off events. On the flip side, have profits been depressed on a similar basis? In addition, are these profits being converted into cash or are they being sucked up by such items as capital expenditure? When we buy a share, we're buying a right to a proportion of the future cash flows generated by the underlying business, not its profits. In the past couple of years, profits (and cash flows) at many companies have taken a severe knock. In many cases, it's likely that average profits will be higher over the next 10 years, assuming economic conditions improve. In such times you should really be happier paying a slightly higher p/e ratio. You're still buying the same company after all. Likewise when times are good you should really insist on a lower p/e ratio because profits are likely to fall back at some stage. In practice though, most of us seem to do the reverse: paying far too much when times are good and next to nothing in times of gloom. The same philosophy applies to the overall valuation of the stock market as well. At the moment the 'average' p/e for UK companies is around 18 times. Although this is higher than the long-term average, which is in the region of 14 times, that doesn't necessarily mean that shares are expensive assuming you believe profits will bounce back. Where next? Quick guide to reading reports | Investing terms explained This article was first published in October 2002.