The price of a stock represents what the market currently deems it to be worth, but figuring out the true value of a share is much trickier than simply looking at what it costs. Market sentiment plays a huge role in determining share prices, so the smart investor has to figure out the intrinsic value of a company for themselves, rather than simply trusting that the market is correct. One of the best ways of doing this is by looking at the Price/Earnings ratio (P/E) of a company.
The P/E is essentially a measurement of how much the market is willing to pay to access a company’s earnings.
It’s a determination of value, not simply price. If we decide that a share is either over-or-undervalued by the market, that can guide our investment decisions.
The “P” stands for price of the share in question, and the “E” stands for earnings per share (total earnings divided by the number of shares). The P/E ratio is the price of a company share divided by company earnings per share. For example, if a share in a company costs $100, and that company has generated $5 in earnings per share, the P/E ratio is 20.
The average P/E across all the companies in the stock market is about 15. In Benjamin Graham’s legendary book, “The Intelligent Investor”, he recommends that you should ideally be looking to invest in companies with a P/E of 10 or under, but that companies with a P/E of 15 are fairly priced. Companies with a P/E of 20 or more are – by Graham’s standards – overpriced and to be avoided. The further above 20 the P/E gets, the more overvalued Graham – and traditional investing theory – would consider it.
As with most stock-related topics, it’s not as simple as all that though. P/E does not reflect the growth rate of a company, and companies which exceed the stock market average growth rate of around 7.5% might be worth buying even if their P/E ratio looks high at first glance. If a company is managing a 15% growth rate, it might be worth buying its stock even if the P/E is 30 – double the average.
The slightly trickier part is taking all these numbers and figuring out what a fair share price is for a given company.
Let’s take an imaginary, average company as an example – the growth rate is 7.5%, the P/E is 15 and the earnings per share is $5. 15 (for the P/E) multiplied by 5 (the $ earned per share) is 75, meaning that the company shares “should” (taking out all other considerations) cost $75. If the shares are currently priced $100 you might be reluctant to invest, but a share price of $50 could indicate that you’ve found a bargain. If the P/E is rate is 30, and you’re OK with that because the company has a high growth rate, the calculation becomes 30 x 5, giving a “fair” price per share of $150. This is all to say that there’s a little more subtlety to all this than simply looking at the P/E and making a snap judgment.
Beyond P/E, always remember to bear in mind the other key determinants of company value such as your circle of competence, company competitive advantages, leadership, and track record.
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