| UNDERSTANDING PE RATIOS by Andrew Palmer May 3, 2007 |
P/E - "Price earnings ratio" is a funny number for humans because it is not linear so
can be misleading if not understood, and future PE can be even more confusing.
Lets start with the basics, "P" is share price and "E" is the earnings per share.
P is easy to understand, but with "E" we need to ensure it is net income of the
company for a 12 month period.
An example:
Company XYZ has a share price of $1 and earnings of $0.20
so we divide 1 by 0.2 and get a PE of 5, Put another way for every 5 dollars we
invested the company should net 1$ in earnings
Take the same example with a share price of $1:
Earnings are $0.05 = PE = 20
Earnings are $0.1 = PE = 10
Earnings are $1 = PE = 1
Earnings are $2 = PE = 0.5 (Very Good company!)
A picture is a thousand words so below I have plotted a chart showing PE vs.
percentage earnings per share. As can be seen they are related but not linear and
as can be seen PE's in the low range like 1-4 are a very rough measure unless you
go into a few decimal places as going from a PE of 2 to 1 is all the difference in the
world:
can be misleading if not understood, and future PE can be even more confusing.
Lets start with the basics, "P" is share price and "E" is the earnings per share.
P is easy to understand, but with "E" we need to ensure it is net income of the
company for a 12 month period.
An example:
Company XYZ has a share price of $1 and earnings of $0.20
so we divide 1 by 0.2 and get a PE of 5, Put another way for every 5 dollars we
invested the company should net 1$ in earnings
Take the same example with a share price of $1:
Earnings are $0.05 = PE = 20
Earnings are $0.1 = PE = 10
Earnings are $1 = PE = 1
Earnings are $2 = PE = 0.5 (Very Good company!)
A picture is a thousand words so below I have plotted a chart showing PE vs.
percentage earnings per share. As can be seen they are related but not linear and
as can be seen PE's in the low range like 1-4 are a very rough measure unless you
go into a few decimal places as going from a PE of 2 to 1 is all the difference in the
world:
Then when you bring future PE into the picture and try to work out a future share
price one must consider the fair value of this type of share. In the general share
market a fair value PE of 14 is normal (7.14% earnings per share)
So if you think the future PE of a company is good and the future PE you worked out
is 3, and you put on a fair value PE of 14 then by definition the company will never
actually have a PE of 3 but the share price will increase to a point where the PE is
14 and thus you have made your money from capital gain.
So again I have plotted this relationship using a fair value PE of 8 in this example,
versus various possible future PE's:
price one must consider the fair value of this type of share. In the general share
market a fair value PE of 14 is normal (7.14% earnings per share)
So if you think the future PE of a company is good and the future PE you worked out
is 3, and you put on a fair value PE of 14 then by definition the company will never
actually have a PE of 3 but the share price will increase to a point where the PE is
14 and thus you have made your money from capital gain.
So again I have plotted this relationship using a fair value PE of 8 in this example,
versus various possible future PE's:
Hypothetical example:
If we are assessing different silver mining companies in one area, and in this area
silver companies normally traded at PE's of about 8, we may expect that the
company being assessed should also trade for a PE of about 8. If we worked out or
found data showing an expected future PE of 4 in 1 year then we would expect the
share price to double within the next year. We can compare this to other companies
and also to physical silver. If we thought silver would double to bring about the future
PE of 4 then maybe we would just buy silver as the outcome would be the same. If
the future PE was less than 4 then buying the stock may be the better option.
Now to take the next step I have potted below various fair value PE's against future
PE's and % earnings per share. To read this as an example: A company we are
looking at normally trades at a PE of 12 and we worked out a future PE of 1 then we
might expect a share price increase of 1100% all going well, Nice!
If we are assessing different silver mining companies in one area, and in this area
silver companies normally traded at PE's of about 8, we may expect that the
company being assessed should also trade for a PE of about 8. If we worked out or
found data showing an expected future PE of 4 in 1 year then we would expect the
share price to double within the next year. We can compare this to other companies
and also to physical silver. If we thought silver would double to bring about the future
PE of 4 then maybe we would just buy silver as the outcome would be the same. If
the future PE was less than 4 then buying the stock may be the better option.
Now to take the next step I have potted below various fair value PE's against future
PE's and % earnings per share. To read this as an example: A company we are
looking at normally trades at a PE of 12 and we worked out a future PE of 1 then we
might expect a share price increase of 1100% all going well, Nice!
So to calculate the future share price the inputs required are future PE and fair value
PE.
So expected share price increase/decrease is:
Fair value PE
---------------- .. = Multiple of SP increase/ decrease
Future PE
For example:
Fair value of 8
--------------- .. = 2x SP gain or 100%
Future Value of 4
For us silver nuts we can simply compare this to our expectation from silver as a
comparison for real return vs. physical silver.
Of course coming up with the future PE in the first place is an art in itself, but just
understanding what it means is important as it is often referred to in stock
assessment reports.
PE.
So expected share price increase/decrease is:
Fair value PE
---------------- .. = Multiple of SP increase/ decrease
Future PE
For example:
Fair value of 8
--------------- .. = 2x SP gain or 100%
Future Value of 4
For us silver nuts we can simply compare this to our expectation from silver as a
comparison for real return vs. physical silver.
Of course coming up with the future PE in the first place is an art in itself, but just
understanding what it means is important as it is often referred to in stock
assessment reports.