A lot of investment commentators refer to a price-to-earnings ratio when writing about shares. But what is this P/E ratio? Why does it matter?
Valuation metric
To understand the role of a P/E ratio, it’s helpful to start by thinking about share prices. A company’s share price helps explain its market capitalisation. If a company has a share price of £1 and 1m shares in circulation, its market cap is £1m. If the share price doubles to £2 and the number of shares remains the same, the market capitalisation would be £2m.
Inflation is out of control, and people are running scared. But right now there’s one thing we believe Investors should avoid doing at all costs… and that’s doing nothing. That’s why we’ve put together a special report that uncovers 3 of our top UK and US share ideas to try and best hedge against inflation… and better still, we’re giving it away completely FREE today!
What does that mean? In theory, it means that if someone came along with £2m to spend, they would be able to buy all of the company’s shares and thus the company. In practice things may be more complicated, as for example a bidder may need to offer a premium to persuade existing shareholders to part with their shares. Nonetheless, a market cap is a good albeit rough guide to a company’s valuation. But how do investors decide such a valuation?
P/E ratio and valuation
One way to do this is by looking at a company’s earnings. Let’s say that to buy the company with a £2m valuation, I want to borrow the £2m. I could hopefully use the earnings from the company to pay back my loan. If the company earnings are £200,000 per year, it would take me 10 years to pay off the £2m. If the price (£2m) is divided by the earnings (£200,000) the arithmetic result is 10. So, we say that the company has a P/E ratio of 10.
In reality, things wouldn’t work quite like that. The longer I took to repay my debt, the more I would usually have to pay in interest. Plus, many companies’ earnings aren’t smooth. So just because a company earns £200,000 this year, it doesn’t mean the same will happen next year.
But a P/E ratio could still give me some important information. A low P/E ratio can suggest the company may be trading cheaply. A high P/E ratio may mean it is overvalued. Even as a private investor looking at the share price, not a takeover firm thinking of buying the whole company, that valuation metric could be useful to me.
Looking at the bigger picture
So, does that mean that Imperial Brands with its P/E ratio of less than seven is a bargain, or that Spirax-Sarco with a P/E ratio over 60 is overpriced?
Not necessarily. That is because earnings could change in future. Imperial’s tobacco focus risks earnings falling as people quit smoking. Spirax-Sarco has demonstrated it can grow earnings, for example by making acquisitions. Using my example above of buying a company with debt then repaying the loan from future earnings, that could help explain Imperial’s low P/E ratio and Spirax-Sarco’s high P/E ratio.
It’s important to remember that a P/E ratio is only one of a number of valuation metrics many investors use. Used properly, though, I do find a P/E ratio is a useful and simple analytical tool to help me make investment decisions. It can help me identify possibly undervalued companies that merit further investigation as potential additions to my portfolio.
