How do you arrive at a valuation using price earnings ratios?

Fsp Invest, 22 Nov. 2013

Tags: price earnings ratio, pe ratio, what is the pe ratio, what does the pe ratio tell you, pe multiple, financial ratio, fundamental analysis, investing

The price earnings (PE) ratio is one of the most commonly used ratios to value a company. Fundamental analysts will use the PE ratio amongst many other indicators to try and find undervalued companies. But what does the PE ratio actually tell you? And what should you be looking for? Read on to find out…

The price earnings (PE) ratio is simply a company’s share price divided by its earnings per share, Gareth Stokes in Fear, Greed and the Stock Market explains…

Let’s take a closer look at how the PE ratio works with the help of an example.

Earnings per share for Company ABC is 11.1 cents. Let’s say that shares in Company ABC are trading at 190c when the results come out.

So Company ABC is trading on a historic price earnings (PE) ratio of 17 (190c/11.1).

But what exactly is this PE ratio?

Well, the price earnings ratio a mix of company-specific factors and market-specific factors.

The company-specific factor is its earnings per share. The market factor is the multiple the market is willing to attach to those earnings.

Multiply these two together and you get the share price.

But why is it a multiple? Is a business not just worth its annual profits?

No it isn’t. The stock market values businesses using multiples.

A multiple is a number that represents the market’s view on the profit outlook for a business. It includes certain assumptions about profits.

If analysts expect a business to make sharply rising profits, the multiple the market attaches to it is higher because of the higher expected profits.

Similarly, if analysts don’t expect a business to maintain its profitability, or it goes through periods when profitability is uncertain, then the multiple the market is willing to attach to it gets smaller.

If a business consistently makes steady profits, then the multiple is also steady. A company producing steady increases in profits will have a gently rising multiple.

In our example of Company ABC, the market attaches a 17 times multiple to the company’s 11.1 cents earnings (multiplying 17 by 11.1) to reach a share price of 190c.

A multiple of 17 indicates the market is confident of Widget’s ability to produce rising profits.

So you want to try and find companies producing rising profits on a small multiple and avoid companies on a high multiple, but not producing rising profits.

So there you have it, how to arrive at a valuation using the price earnings ratio.

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