What the price earnings ratio really means

Julie Brownlee, Fsp Invest, 05 Jun. 2014

Tags: price earnings ratio, pe ratio, how pe works, how pe ratio works, investing, ratio, what pe ratio means

The price earnings (PE) ratio is one of the most widely cited ratios on the stock market. But what does it actually mean in practice? What’s the difference between a share trading on a PE of 6 and one trading on a PE of 30? Let’s take a closer look…

The PE ratio in action

Let’s say Company XYZ made R1 million in profit last year:
  • If you buy Company XYZ at a market capitalisation (cap) of R6 million, you’re paying six times its earnings.
  • If you buy Company XYZ at a market cap of R20 million, you’re paying 20 times its earnings.
  • And if you buy Company XYZ at a market cap of R50 million, you’re paying 50 times its earnings.

(A company’s market cap is just its share price multiplied by the number of shares in issue.)

The stock market is full of different investors, Brian Hunt in Daily Wealth explains. And depending on a variety of factors, investors will behave differently.

So one month these investors might say Company XYZ is worth R6 million. The month before, these investors might have said Company XYZ is worth R8 million or R10 million.

This might sound a bit crazy, but it happens all the time in the stock market as the prices of shares move up and down.

What a company’s PE ratio tells you

The amount that investors will pay for a company’s earnings, as you saw above, is the PE ratio.

As an investor, it’s a better deal to buy shares in Company XYZ when the market values it at R6 million, or a PE of six, than buying shares when the market values it at R50 million, or a PE of 50.

You get more value for your investment rand. The lower the PE ratio means you’re buying shares in a business producing profits for a lot less.

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And you can use the PE ratio to help you ensure you’re not overpaying for shares. A low PE reflects an undervalued share. A high PE reflects an overvalued share.

But be wary of shares on abnormally low PEs. There could be a very good reason why the share price is so low.

So there you have it, what the PE ratio really means.

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