Interpreting the Price/Earnings Ratio

People who own shares want to know one thing above all - which way is the share price headed? Without reaching for the crystal ball, there is a financial ratio that can give us some clues on whether shares are cheap or expensive. Most business journalists fight shy of this ratio, and so do the majority of investors. It's hard to understand why. The p/e ratios is simple to calculate and probably the most consistent red flag to excessive optimism and over-investment. It also serves, regularly, as a marker of business problems and opportunities. So, if you can bear to divide one number by another and interpret the results, our advice is: it's worth the effort! Calculating the Ratio The starting point for the P/E ratio is the share price. This is the P. The P/E takes this share price and divides it by earnings per share (which is the company's entire net profit, or earnings, divided by the number of shares in issue). This is the E. Together these two numbers relate the market's valuation of a company's shares to the wealth the company is actually creating. Why connect price to earnings? Any share price is built on expectations of a company's future performance. Some of these expectations will be based on fundamentals - such as the company's recent performance, its new product lines, and the prospects for its sector. The rest will reflect prevailing moods, fashions and sentiment. By relating share prices to actual profits, the P/E ratio highlights the connection between the price and recent company performance. If prices get higher and profits get higher, the ratio stays the same. The ratio only moves as price and profits become disconnected. For this reason, when the ratio is higher or lower than normal we know that recent profit levels are no longer the main factor in pricing. This might be because change is afoot - investors expect a much better or worse performance next year - or because sentiment is now the dominant factor. Either situation is news worthy. How it works in practice In the summer of 2001, the average P/E ratio across all shares listed on the London Stock Exchange was running at around 21. Yet the average P/E for Telecom was 67. Immediately we can see that share prices are far higher for Telecom companies, compared to profit levels, than they are for companies generally. If we look for fundamental reasons for this, we can see that the sector has been hard hit recently by licence costs and the global economic slowdown. So current profits may be unusually low. Investors obviously "feel" certain of a better performance in future. Indeed, a P/E of 67 suggests expectations of huge forthcoming profit hikes. But how justified is this? And are we now looking at shares that are appropriately valued on the basis of future profit expectations alone? Testing for future profits Generally, we test for the importance of future profits to the current P/E by building a prospective P/E ratio. This takes the current share price (P) and divides it by forecast earnings per share (E) for next year, and even the following year. We get these earnings forecasts from stockbrokers' analysts. If next year's profits are on course to be significantly higher than this year's, the prospective P/E ratio will be lower than the current P/E ratio. For companies and sectors in take-off or rapid growth this often turns out to be the case. The abnormally high current P/E ratio simply reflects future profit levels - they have already been written in to the share price. However, in the case of telecom, shares still look over-valued when we take into account forecasts for future growth and profits. This mismatch between outlook and share price is, in fact, typical in a sector whose character has changed rather suddenly. In the recent past, telecom was a rapidly expanding and technologically advanced sector benefiting from premium pricing for its products. The first thing to change was the premium pricing, as market saturation pushed telecom services into aggressive price-cutting. This continued even with the next generation technology, WAP, which failed to trigger substantial new business. Then came massive new costs - funded through heavy debts - as licences were auctioned. Together, these changes made for a sector of a whole other nature than five years earlier. And that was before the downturn! Currently, telecom is a saturated market with virtually no technological differentiation, too many suppliers and too much debt. Unfortunately, when an entire sector pulls off a change in character as swift as this, investors are sometimes slow to appreciate the underlying nature of the shift. Expectations of a recovery to the golden days can linger long after the factors that made for the initial heyday have disappeared. So, we end up with a sector with huge sentiment still built into pricing. Make up you own mind whether this will be: sustained forever, eventually supported by an improvement in the fundamentals, or ultimately corrected out of the share price. The P/E as a red flag In fact, we have repeatedly seen this kind of red flag over fashionable sectors: perhaps most recently in 1998/1999 over the Internet industry. The surprising thing is that we have not yet fully absorbed its significance. We have certainly seen it enough times. Thirty years ago, smart investors were buying only into the so-called Nifty Fifty. This elite club included companies such as IBM and Coca-Cola, which in the eyes of many could do no wrong. However, once the P/E ratios on these companies had moved into the 60 to 90 range, the party was over. Even these companies couldn't deliver the profit growth necessary to support share prices at this kind of multiple. The Nifty Fifty subsequently produced way below average returns for close to the next decade. Moreover, on every single occasion where the P/E ratio for the entire market (not just one sector) has risen substantially above 25 there has subsequently been a marked correction in the market (a sharp fall in share prices). The P/E behaving normally Of course, to spice things up, a high P/E can also mean the opposite of trouble - it may just be the marker of a true growth industry. Before you can spot red flags, you need to know what is normal for the P/E. For instance, each sectors' average P/E reflects the speed of expansion in that industry, how cyclical it is - industries that traditionally move from boom to bust every 6 to 10 years tend to have rather low P/Es - and its rate of technical renewal. Average P/Es also shift depending on the position in the economic cycle. Construction company shares will be far more highly valued as we enter an upturn than they are with a slow-down approaching. To find P/E ratios for whole markets and different sectors check tables such as the Actuaries Share indices in the FT, or look for an extra line under each sector in the straight share price statistics. For prospective P/Es for entire sectors and markets we again go to the brokers' analysts. It's also worthwhile watching for the highest or lowest individual P/Es within each sector. If a P/E or prospective P/E is lower than the norm for a sector, we say the share is at a discount - it's relatively cheap. Conversely, when an individual P/E is higher than the norm, we say the share is at a premium, that is, relatively expensive. But, in fact, the vital element in determining whether this share is truly a bargain are the reasons for the current valuation ... and their validity. Prices beyond reason On its own, each P/E ratio is meaningless. The P/E points us to optimism or pessimism, which we must then find the reasons for. In doing this, we reach vital information for our business readers. For example, a massively high P/E is sometimes the result of a rumoured take-over. Or it may reflect an industry in tatters, where the share price is yet being supported by small shareholders reluctant to face reality - retaining their holdings in the hope of better times. It may equally reflect confidence in a new product that's set to be a blockbuster! Whatever the story behind a variation from a normal share valuation, investors should know about it. Above all, the underlying reasons for current levels of optimism (or pessimism) are critical in determining whether such valuations are likely to persist. So, remember, no one P/E ratio has a fixed meaning (good or bad). There is no cut-off for what is high or low. There is, however, normal and abnormal. So, get familiar with the normal. Then you can use the abnormal to get straight to the places where share prices are most definitely moving out of step.