How best to use the PE ratio

Julie Brownlee, Fsp Invest, 05 Nov. 2014

Tags: pe ratio, price earnings ratio, using the pe ratio, how to use the pe ratio, investing, financial ratios,

The price earnings (PE) ratio is one of the most well-used and quoted ratios in the investment realm. But are you paying too much attention to it?

If you base many of your investment decisions on this one ratio, you could be misled and make the wrong choices.

So what should you do?

Read on to find out…

What is the PE ratio?

The PE ratio is simply a price of a share divided by its earnings per share. For example, if a share is trading at R40 and its earnings per share is R2.50, its PE ratio is 16.

Generally speaking, a high PE suggests that you should expect higher earnings in the future for the company.

But when earnings plummet, this can send the ratio through the roof, Christopher Rowe in Investment U explains.

Markets tend to trade between certain ranges of PE.

Take the world’s largest stock market index, the S&P 500. Looking at 88 years of data, it tends to stay within 10 and 20. But in 1949 it dropped to 5.9. And in 2008 it hit 60.2.

It’s currently around the 19 mark.

Generally speaking, when the PE strayed higher, markets tended to fall within the next year or two. On the other hand, when the PE was lower, markets tended to rise within the next year or two.

But there were times when the PE was high and the market went on to perform fantastically for many years.

How to use the PE ratio

When you use the PE ratio, bear in mind that earnings can be subject to a bit of manipulation by companies. If the earnings aren’t accurate and true, then the PE isn’t either. Things like share buybacks also affect earnings.

Plus what earnings do you use? Historic? Future? Neither of them are going to be exact at the time you calculate the PE.

So you need to look at some other calculations to get a better picture. This includes ratios like:

  • Price to book value;
  • Price to sales; and
  • Price to cash flow.

You also need to look at a company’s growth prospects in addition to its valuation compared to its peers. This means comparing the PE ratio and the above ratios with other companies in the same sector and business.

So there you have it, how best to use the PE ratio.

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