Learning about shares: Minding your P's and E's

Barbara Kendall asks: You mentioned the price/earnings (P/E) ratio last week when we talked about growth investing and value investing. What's so special about P/E?

Dan Dividend responds: This is one of the questions I'm asked most often. It's not surprising, as P/E ratios get bandied about among seasoned investors in many a dinner-table discussion. P/E is an important sharemarket measure that new investors should understand, too. It's recorded in the far-righthand column of the sharemarket table.

Basically, the P/E ratio shows the relationship between a company's share price and its earnings (or profits). To calculate P/E, you divide a company's share price by its earnings per share: the price side of the ratio is the share price at the end of the most recent trading day (as reported in the "last sale" column of the sharemarket table).

The earnings or EPS side is the company's last reported full-year earnings divided by the number of shares in the company. It shows how much the company has earned for each of its shares.

The Business Herald's table lists P/E only where companies are making a profit.

In theory, P/E can be used to show how much investors are willing to pay for a dollar of a company's profit. For this reason it's also called a multiple. Say a company has a P/E of 20. This suggests investors are willing to pay $20 for every $1 of profit that the company generates.

In practice however, this way of using P/E ratios or multiples is over-simplistic, because it fails to take the business' growth prospects into account.

In general, a high P/E means expected profit growth in the future. If you think back to our discussion of growth stocks and value stocks last week, we noted companies that are expected to grow rapidly often have high P/E ratios in line with their expectations of high profit growth.

We've asked our guest broker, ASB Securities managing director Tim Preston, to explain how you might use P/E to evaluate shares. Tim says:

I get this question a lot too, Dan. For investors starting out, it's most useful to think of P/E as a valuation yardstick.

If you run your eye down the P/E ratio column in the newspaper share table, you will see that P/E varies a lot between businesses and industries.

There's no optimal P/E ratio for a share and there are lots of different reasons it varies so much between companies.

The most significant reason for differing P/Es is how the market views a business and its industry's growth prospects and future earnings potential.

Generally, companies with the highest P/Es operate in high growth industries and are expected to impress with fast-growing profits in the future.

Companies operating in mature industries, where the potential for dramatic growth isn't so great, tend to trade with much lower P/Es.

P/E is most usefully used in comparing similar businesses in the same industry.

When considering the merits of the different companies in an industry, a variation in P/E ratios can be a good kick-off point to dig a little deeper. For example, if one company has a much higher P/E than a similar company in the same industry, you could try to find out why.

This could highlight potential buying opportunities and give you an overall feel on how the market perceives companies' and industries' prospects.

NZX firms employ skilled analysts whose job it is to understand things like the reasons for P/E variation between companies. Your NZX adviser will be able to discuss this with you.

However, keep in mind that while P/E ratios are a good starting point, they are only one of several things you should look at when evaluating a business as an investing prospect.

NEXT: What does it mean when a company pays a dividend?

GOT A QUESTION? Feel free to email Dan Dividend with your questions