If a quoted company has a share price of $100 and EPS of $12 for the last published year, then it has a historical P/E of 8.3. If analysis are forecasting for the next year EPS of $14, then the forecast P/E is 7.1.
In the above example, the P/E of 8.3 tells us that investors at the current price are prepared to pay 8.3 years of historical EPS for the share, or 7.1 years of the forecast next year's EPS.
Theoretically, the faster a company is expected to grow, the higher the P/E ratio that investors would award it.
P/E is one measure of how cheap or expensive a share appears.
HOW IT WORKS IN PRACTICE
The P/E ratio is predominantly useful in comparisons with other shares rather than in isolation.
For example, if the average P/E in the market is 20, there will be many shares with P/Es well above and well below this, for a variety of reasons.
Similarly, in a particular sector, the P/Es will frequently vary quite widely from the sector average, even though the constitutent companies may all be engaged in broadly similar businesses.
The reason is that even two businesses doing the same thing will not always be doing it as profitably as each other. One maybe far more efficient, as demonstrated by a history of rising EPS compared with the flat EPS picture of the other over a series of years, and the market might recognize this by awarding the more profitable share a higher P/E.
TRICKS OF THE TRADE
1. Take care.
- The market frequently gets it wrong and many high P/E shares have in the past been the most awful long-term investments, losing investors huge amounts of money when the promise of future rapid growth proved to be a chimera.
- In contrast, many low P/E companies, often in what are perceived as dull industries, have proved over time to be outstanding investments.
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