PE, or Price-to-Earnings Ratio, is one of the favourite go-to metrics when evaluating a business. The first question usually asked when talking about a stock is “What is the PE ratio?”. This immediately tells a potential investor how cheap or expensive the stock is.
Price-to-Earnings Ratio is calculated by taking the price of the stock (share price) and dividing this by the earnings per share (earnings per share is calculated by taking a stock’s net profit and dividing it by the outstanding shares).
The ratio essentially tells us the price we are paying for earnings. For example, if the PE ratio is 20, then, if all things stay constant, it will take us 20 years to get our money back. If a stock is priced at 10p and earns 2p per share, then the PE ratio would be 5. If we hold the shares for five years, then we will earn 10p from the stock – the same amount as the current stock price.
The fundamental problem with the PE ratio is that it only tells us how the business is valued, not how the company is actually performing.
The Value Trap
Cheap stocks can often, in reality, be expensive. These are commonly referred to as “value traps”.
We can spot a value trap by identifying cheap stocks that are the producers of declining earnings. For example, the same stock referred to earlier at 10p can be on a PE ratio of 5 with earnings of 2p, but what happens when new earnings are released with the earnings at 1p?
The stock would then currently trade on a PE of 10 – the stock becomes more expensive despite the deterioration in earnings! It would then likely re-rate back to the old PE, and perhaps become even cheaper, as investors realise they are holding a stock that is losing in its battle for profitability.
As investors, we should try to avoid value traps by doing proper due diligence when investigating cheap stocks. They are not always what they seem, and a simple check on the trend in net income (not earnings per share) will tell us whether a stock is cheap because of declining earnings or actually cheap in terms of its growth rate.
Earnings per share can be manipulated
Almost every line on the income statement can be a figment of management’s imagination. We only see what they want us to see, and how they decide to depreciate and amortise is at their own discretion. I have heard one financial controller say they decide what they want the earnings to be and then they create the earnings to be – funnily enough – exactly that.
Another problem with earnings per share is that many companies can plaster over gaping holes in the business by buying back shares. Share buybacks are healthy if there is a clear case for a business being undervalued, but very often an ex-growth firm will pretend it is still a growth business by spending some of its cash on buying back shares and reducing the outstanding shares in circulation.
This has the effect of boosting earnings per share (EPS) and giving the impression of continuing profitability.
EPS also factors into account dilution as well as concentration. A share placing to shore up a weak balance sheet will reduce EPS as the profit is now divided by an increased number of shares.
Alternative to PE
PE is handy to know but an investment decision should never be based on any single metric alone, and certainly not PE.
The PEG ratio (Price-to-Earnings-to-Growth ratio) takes into account the PE ratio and then divides this by the business’s growth rate in EPS. Again, this is not perfect. However, it gives a better overview of how the company is performing.
For example, a stock that is currently valued on a PE of 20 but is growing its earnings at 40% per annum could be labelled cheap – despite the PE of 20 appearing expensive. If you’re paying 20x earnings but getting 40pc growth, it can be much like buying a tenner for a fiver.
This stock would be priced on a PEG of 0.5. Anything below 1 can be considered cheap, whereas a PEG value above 1 could be regarded as expensive as we are paying more for earnings than the business is actually growing.
However, these ratios are static and, like anything, should not be used in isolation. Valuation work can be complicated and tricky, and there are many metrics to use, but I would always use PEG over PE to get a better judgement on the value of the shares.
You can learn more by downloading Michael’s fantastic free book How to Make Six Figures in Stocks. This can be downloaded from his website – https://www.shiftingshares.com/