FOOL SCHOOL
Valuation: The P/E Ratio

February 3, 2003

This is the first of nine articles looking at how to value shares. A few words of warning to begin with though. Valuing shares or indeed any other asset is not a precise science. It's more of an art. There are no definitive answers to whether a share is cheap, expensive or about right. Most people use a number of valuation measures in order to get a feel for whether a share offers good value or not. It's also important to be consistent about how you use valuation measures. For each different method there a number of ways you calculate the answer. If you want to compare valuations at different times or for different companies you have to make sure you're comparing apples with apples.

The P/E Ratio

The price to earnings ratio (P/E) is the most widely quoted number when investors attempt to put a value on a share. You will often see something like "Dodgy.com trades at a forward P/E of 10, making it look fully valued," or "Epic! 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 Epic! thought to be "cheap"? And what is the difference between a forward and a trailing P/E?

The P/E is calculated as:

EPS is calculated as:

Let's take an example. Epic! is a relatively new company but it is already profitable. Last year it made the conveniently round number of £1m in profits after tax. Even more conveniently it has 10m shares in issue on the stock market. So its EPS can be calculated as:

Epic!'s current share price is 300p, so the P/E is:

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. However, whilst the 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 what does that mean? Is Epic! incredibly cheap or wildly overvalued? 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 (you can find this information on the back page of the Financial Times Companies & Markets section or the FTSE web site).

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, which is what the rest of this series of articles will concentrate on.

More on valuation
1. Price to earnings
2. PEG
3. Price to sales
4. Dividend yield
5. Return on equity
6. Adjusting for goodwill
7. Uses of return on equity
8. Balance sheet basics
9. Discounted cash flow