The Magic of the PE Ratio

This is a guest post by Omar El Foudeh.

Omar is extremely knowledgeable with technicalities which relate to financial trading and has a wealth of experience working in the financial markets.

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The star of value indicators has always been the Price to Earnings ratio. To make sense whether a stock’s price is high or low, we can always compare it to how much the company is making in profits.

Lets say a company has 40 stocks issued, and for the past years profits have been around $400, this means it has an earnings per share of $10 ( 400 profit / 40 shares)

Now if the stock price is at $100, what does that mean?

- For every 1 dollar of investment, you make a 10% return ( 10 earnings per share / 100 share price)

- In other words, the reciprocal is you are paying $10 dollars for every $1 dollar in earnings, thus a PE ratio of 10 ( $100 share price / $10 earnings per share)

So now if you believe that a earnings yield of 10% is fair, or that paying 10 dollars for every 1 dollar in earnings is fair, you have a fair value PE ratio to bench mark market prices

If earnings next year rise to $20 per share, the stock price would have to rise to 200 to keep earning the same return of 10% ( 20/200).

Our PE multiple is still at 10 But now lets say instead of it going up to $20, traders took up the share price to $30.

Suddenly your key metrics change.

- Your earnings yield dropped to 6.67% ( $20/$300)

- At a PE of 15 ($300/$20) you are paying 15 dollars for every 1 dollar in earnings

Why would the market change its valuation of the stock by trading at a higher PE than the past?

Usually its because they have rosier future expectation of profitability ( if they expect profits next year to rise to 30, then the PE goes back to 10 at a price of $300 ( $300/$30 =10)

However if the value trader doesn’t share the markets optimism, suddenly the stock doesn’t look so attractive. Its no longer earning the 10% he requires and as a result might not invest, specially if he can ear 10% else where in other company shares or asset classes.

This was he is using the PE multiple to compare different stock prices to relative to each other who is offering the better return, and can adjust his portfolio accordingly.

Thus by comparing the stock price to a key financial metrics such as profits, the value investor was able to decide whether or not the current stock price is attractive for him and use the PE ratio as a key signal