Price Earnings Ratio: How you should (or shouldn’t) use it to find undervalued stocks
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“We’re dipping into a bear market, but there are many good stocks that look cheap out there.”
We’ve all heard that comment before, but what does that really mean, and how do we determine whether a stock is cheap or not?
The answer revolves around the Price Earnings Ratio (or P/E ratio) – a classic measure that helps investors gauge whether a company is cheap or expensive in the market.
It’s simply the current stock price divided by the company’s earnings per share for a designated period, usually the past 12 months.
If a company is trading at $100, and its earnings per share is $5, then the P/E ratio is 20.
But what does a P/E ratio of 20 actually mean?
In simple terms, a P/E ratio conveys how much investors are paying per share for every dollar of profit a company makes. In the above example, you’re paying 20x its yearly profits.
The higher the P/E ratio, the more you’re paying for the stock and vice versa.
So how do we use the P/E ratio to find cheap stocks in the market?
There are two ways:
1. You can compare the P/E ratios of stocks within the same sector, or
2. You can use it to compare against the broader market (such as the S&P/ASX 200 index).
When comparing between stocks, it might seem intuitive just to choose one that has a lower P/E, but unfortunately it’s not that straightforward.
Let’s see why this is the case.
At face value, you might think CSL is a cheaper stock based on its lower P/E.
But we’ve failed to take into account one critical component — the expected future earnings growth that’s priced into every stock price.
In this example, Pro Medicus ($4bn market cap) is a much smaller company than CSL ($130bn market cap).
Investors therefore expect that Pro Medicus will grow its earnings at much quicker rate than CSL, and are therefore pricing in a higher growth rate in PME’s stock price.
Indeed, Pro Medicus’ growth rate for the next five years is 36%, while CSL is assigned 12% by the market.
The conclusion? A stock with a higher P/E ratio is not necessarily more expensive. It could indicate that it’s a high growth company.
Dean Fergie, portfolio manager at Cyan Investment, explained to Stockhead that by the same token, a lower P/E ratio may not necessarily mean that you’re buying into a cheaper stock.
“Companies that have low P/Es could be businesses that are going backwards, or those that are cyclical or mature,” Fergie told Stockhead.
In other words, a stock could be cheap due to many reasons such as losing market share.
“When you compare a stock against a cohort of similar stocks that are trading on higher P/E multiples, you might think there’s a disconnect there.
“But a P/E ratio doesn’t always indicate the future direction of the share price,” Fergie added.
The other way to use the P/E ratio is to compare a stock against the broader market.
According to Commsec, the long-term trend for the P/E ratio of the ASX 200 is around 15x.
So generally speaking, an ASX 200 stock that trades below the 15x multiple could be considered cheap over the long run.
One of the challenges in using P/E ratios on small caps is that it might not be relevant.
P/E ratios of smaller companies might be skewed to the upside especially on stocks like tech, due to the high growth estimates used.
“P/Es are very relevant for stocks that are very stable and mature. And that’s just really not applicable for a lot of small caps,” explained Fergie.
It’s also not applicable for companies with no profits.
Fergie says depending on the situation, there are other metrics apart from P/E that fundies use for comparative valuations.
“Price earnings is the most traditional measure, but there are other metrics out there that we use,” he explained.
This includes metrics such as Enterprise value/EBITDA, Price/Net Tangible Assets, or Net Asset Value (NAV).
Medium and Large caps
This is because of the low growth rates associated with the coal sector, as the world moves towards renewables.
Medium and Large caps
“Some of the highest growth businesses don’t even have much earnings, but but the market tends to like metrics like big increases in customer base or revenues,” Fergie explained.
“A good example is Xero. They’re a $13 billion market cap that doesn’t make much money at the bottom line ($20m in FY21). So it’s got a very high P/E ratio as a result.”