INSIGHTS

The price to earnings (PE) ratio is the most common valuation metric in investing. It is great as a short-hand measure to gauge how cheap or expensive shares in a company are. However, its use can be limited and it needs to be considered alongside a series of other quantitative and qualitative factors.

What is the price to earnings ratio?

The PE ratio compares the share price of a company to its annual earnings per share. It essentially shows how much an investor is paying for their share of a company’s earnings.

So if a company’s earnings per share are $1, and you pay $15 a share, the PE ratio is 15x.

With all else being equal, the lower the PE ratio, the cheaper a company is.

Another way to interpret a PE ratio is that it shows how many years it will take for an investor to recoup their initial investment (assuming earnings stay flat).

Using the price to earnings ratio

As an example, let’s compare the PE ratios of two of New Zealand’s largest companies: Fisher & Paykel Healthcare and Spark. Using expected earnings per share for the year ahead, F&P Healthcare is trading on a PE ratio of around 40x, while Spark trades on a PE ratio closer to 20x.

Does this mean we should have a preference for the cheaper company, Spark in this example? Not necessarily. Generally speaking, an investor will be willing to pay more for a company with greater prospects for earnings growth than for a company which has limited growth opportunities.

F&P Healthcare’s higher PE ratio reflects the fact that its earnings are expected to grow more quickly – it has large market opportunities, especially with its Optiflow product in the US. Meanwhile, Spark operates in an industry with a more challenging demand outlook, and therefore more limited ability to grow earnings. It does, however, pay an attractive dividend and has a lower risk profile, so may be more attractive for some.

Nonetheless, the PE ratio is useful to assess the current valuation of a company compared to where it has traded historically, or to compare companies across the same or similar industries.

Other factors to consider

The PE ratio is just one tool in the investing toolkit. When looking at a company, we also need to form a view on management’s ability to execute on its opportunities, how strong a company’s cash flow is, the inherent quality of a business, its competitive advantages, and how earnings would respond should economic conditions deteriorate.

There are also some shortfalls with the PE ratio itself. For example, a high level of non-cash costs (such as depreciation) can also distort the earnings per share figure, making a PE ratio much less meaningful. This is often the case with utilities and infrastructure companies, such as Vector and the electricity sector. In these instances, other valuation measures (such as the EV/EBITDA ratio) are more appropriate. In addition, differences in debt levels between companies can make a comparison based on PE ratios less useful.