What does the PE ratio really tell you?

Highlights in this issue:

*** What is a PE...?
*** Can you rely on this ratio...?
*** Other numbers you should be interested in... and more...

From Gary Booysen on the top floor...

Dear Investment Academy Reader,

So you’re interested in the world of investment. Perhaps you’ve even been to a seminar or two.
But no matter what your level of investment experience, you’ve come across the PE ratio before. The price earnings ratio (PE) is the most ubiquitous number in investment today. It’s among the most popular methods of rating a share and it’s easy to see why. It’s quick and it’s simple to use... But, how useful is it really?

Tim Bennett from MoneyWeek wrote a fantastic article recently about these little guys and I just had to share it with you. It’ll show you the basics of a PE ratio and help you understand the other important ratios out there.

Without further ado, over to Tim...

The basic concept

The PE’s simplicity is also a pitfall. The “historic” PE takes today’s share price and compares it to the past 12 months’ earnings per share (EPS) after tax. So a price of R2.20 and EPS of 10c (one year’s earnings divided by the number of shares in issue) gives a PE of 22. The higher the PE, the more costly the share in earnings terms. The FTSE 100 average is around ten, so you need good reason to buy a FTSE 100 share on a PE of 22.

But this is the first trap. A low PE of five might represent a bargain – very crudely (and ignoring inflation) it suggests it will only take you five years to get back the money you spend on the share. In other words, a low PE compared to its sector or index may just mean that a share isn’t worth buying.

Don't just settle for 12 months of data

Other drawbacks are that the classic PE uses last year’s earnings figure. It also only looks at one year, a problem when earnings are volatile. And if a firm is losing money, the PE is useless. You can use a “forward” PE, which compares the current share price to expected earnings for the next 12 months. The snag is, you need a reliable forecast and the credit crunch has made earnings very hard to predict.

Another option is to use Yale professor Richard Shiller’s PE ratio, which tries to adjust for swings in profitability. Rather than look at one year’s earnings, Shiller averages the last ten years. But even this is no panacea. As the Financial Times’ David Stevenson notes, “it’s quite obvious that [the Shiller PE] can vary significantly over time”. Today, the US market is trading at close to its 130 year average Shiller PE of around 16. But whether you think US shares are still worth buying, depends on your view of the US economy.

You should use these 3 numbers NOW

If you could get rich using one number, we’d all be doing it. A better approach is to use several numbers and look for a pattern. There are three particularly useful ones. The price book ratio – the share price compared to the firm’s balance sheet net assets per share – is good in asset-intensive sectors, such as telecoms and property. The lower this ratio the better, as this indicates you’re not paying a whopping premium to buy the firm’s assets. Next, price/free-cash-flow ratio.  This is a measure of cash generated from operating activities, after deducting interest on debt, the tax bill, and the spending (capex) needed to keep the business going (analysts often deduct a year’s depreciation as a proxy for this). Again, the lower the number the better.

Finally, the dividend yield. When a company must pay dividends, managers focus on generating regular cash flow.  The FTSE 100 average yield is just under 5%, so anything above that is a good sign – as long as cover (the ratio of profit before dividends to the ordinary dividend) is two or above.

So, before you buy another share, make sure the ratios are in your favour.

Until next time – keep learning!

Gary Booysen
For the Investment Academy