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Before choosing stocks or packages of stocks for investments, investors study the charts and reports of companies but often miss an important coefficient/index – P/E (Price/Earnings). Let us try to find out what is this index and how we can use it.
What is P/E?
P/E is a multiplier used for checking if a company is overpriced or underpriced and shows its primary investment attractiveness for investors. Based on P/E, you can conclude how fast your investments in a company will pay off.
How P/E is calculated?
P (Price) is the company’s capitalization or, in other words, its exchange price. It is calculated by multiplying the price of one stock by the whole number of stocks in circulation.
For example, the X company has 1 million stocks in circulation; the current stock price is 2 USD. This means the company’s capitalization is 2 million USD.
E (Earnings) is the company’s net profit for the reporting period. Normally, for calculations, we use the data for the last calendar year. Also, in certain cases, we use the forecast profit that the company will receive in the future or sliding profit. Note that sometimes this index is overstated to make the company more attractive, but later, it might decline. To put it simply, P/E tells us how long it will take your investments to pay back.
The lower the index, the sooner it will happen.
However, things are not as simple as they seem. A low P/E value means that the company is underpriced, and its stocks will be moving towards a fair price, which will make the earnings of the investor in the long run. On the other hand, low P/E might mean some negative background or serious problems in the company.
A P/E value higher than the market average means that the company is overpriced, so investments in it might not pay back in the medium or long run.
3 ways of calculating P/E
There are 3 ways of calculating P/E, which are:
- Yearly (normal) is the P/E of the previous calendar year.
- Sliding P/E is the P/E of the previous four quarters, regardless of the quarter when it is calculated.
- Forward P/E is forecast P/E. The calculation is made at the beginning of the fourth quarter – for the future.
Yearly P/E: in the new 2021, we calculate P/E based on the profit and stock rise in the previous 2020.
Sliding P/E: at the end of Q1, 2021, we form P/E based on three quarters of 2020 and the first quarter of 2021.
Forward P/E: at the beginning of Q4, 2021, we forecast P/E. The values of Q4, 2020 will be nonobjective due to the change in market conditions. Based on preliminary calculations and forecasts, we calculate the multiplier for the next quarter. The calculation will be conditional, however, it will show some perspectives of the company and make some forecasts.
How to use P/E?
To realize the perspectives of investments in a certain company, it is not enough just to know its P/E. You need to compare it with other indices as well, which are:
- Average market P/E
- Average P/E in the sector (ex., healthcare)
- P/E of rivaling companies, or those in a similar sector
- P/E of the company in previous report periods.
Because of the development of computer technology and the Internet, investors do not need to calculate P/E manually anymore. On popular resources about stocks and the stock market, this index is ready for analysis and comparison.
In the screener, you can specify the calculation period for P/E (up to 5 years) and analyze the data.
Advantages and disadvantages of P/E
- It helps to look for and find companies with a positive investment potential that are underestimated in the market or, perhaps, are not known to the wide circle of investors.
- It helps choose stocks in your sector faster.
- It simplifies the evaluation of the company’s attractiveness: you can easily sift away companies with too low/high P/E.
- It simplifies forecasting price movements: an underestimated company has better growth potential.
If the average value in the sector is 15, and the company you are interested in has its P/E at 10, the company has some room to grow. If, on the contrary, the average value is 15, and the company has it at 25, the potential of growth is low.
- It cannot be applied to losing companies: for such, there is P/S (Price/Sales ratio). P/E analyzes just the ratio of the fair price to the market one. However, other parameters influence the growth of the company (dividends, market/sector situation). You cannot compare the P/E of different sectors (ex., it is incorrect to compare P/E from the biotech sector and heavy industry).
- It is also incorrect to compare companies in different stages of development. Young companies spend a large part of their profit on capital expenses; as a result, their P/E is high. “Mature” companies have smaller profits but also smaller spending, which makes their P/E lower.
- Investors only need to decide which company to choose: a swiftly developing one with high P/E or a stable one, with a low potential for growth but a low P/E as well.
For the US market, normal P/E is between 15-20. P/E is conditional because both profits and market prices keep changing both in the positive and negative directions.
It is incorrect to assess stocks just by P/E, however, it is an important part of such assessment. A full-scale assessment requires making note of many parameters.
Also, note that it differs not only from sector to sector but also from country to country. The US market is more conservative, hence, the average P/E will be high. Here, investors are ready to wait for 15-20 years for stocks to pay off.
Other important criteria for assessing stocks are dividend payments, trade values per session, recommendations of analysts, insider trades, and capitalization. In subsequent articles, we will talk about them in detail.