Price/earnings ratio

5 Price/earnings ratio

The price/earnings ratio (P/E ratio) is the value of a business divided by its profits after tax.

Once you have decided on the appropriate P/E ratio to use (see below), you multiply the business’ most recent profits after tax by this figure. For example, using a P/E ratio of 5 for a business with post-tax profits of £100,000 gives a P/E valuation of £500,000.

5.1 P/E ratios are used to value businesses with an established, profitable history.
• P/E ratios vary widely
Multiple values
A small unquoted business is usually valued at between five and ten times its annual post-tax profit. Previously — most notably in the IT market — the ratio has exploded, with some valuations being drawn from multiples of 70 or more. However, the differential has closed significantly, with IT-based companies seeing the sharpest drops.
Following the so-called ‘correction’, commonly accepted earnings multiples to value quoted firms range from nine or ten to 25, although some exceptions remain.

5.2 Quoted companies have a higher P/E ratio. Their shares are much easier to buy and sell. This makes them more attractive to investors than shares in comparable, unquoted businesses.
• A typical P/E ratio for a large, growing quoted company with excellent prospects might be 20.
• Typically the P/E ratio of a small, unquoted company is 50 per cent lower than that of
a comparable quoted company in the same sector.

5.3 Compare your business with others.
• What are your quoted competitors’ P/E ratios? Newspapers’ financial pages give historic P/E ratios for quoted companies.
• What price have similar businesses been sold for?

5.4 P/E ratios are weighted by commercial conditions.
• Higher forecast profit growth means a higher P/E ratio.
• Businesses with repeat earnings are safer investments, so they are generally awarded higher P/E ratios.

5.5 Adjust the post-tax profit figure to give a true sustainable picture.
How to calculate profit
If you are considering buying a business, work out what the ‘true’ profitability is.
A Compare the owner’s stated profits with the audited figures.
• Question any differences.
B Look for costs which could be reduced under your ownership. For example:
• Consultancy fees.
• Payments to the owner and to other shareholders.
• Unnecessary property leases.
• Supplies — is there a cheaper supplier?
• Overlapping overheads.
C Look for areas to ‘restate’ (the accountancy term for changing a figure from one kind of cost to another). For example, money spent on software development may have been capitalised by the owner. You might consider that it should have been treated as a cost.
• Use your own accounting policies when calculating the business’ profits.
This will often result in a significantly different profit figure.
D When looking at future profits, bear in mind the costs of achieving them. These may include:
• Servicing increased borrowings.
• Depreciation of investment in plant, machinery, or new technology.
• Redundancy payments.
The arrival of new management often leads to major changes which may mean higher costs and lower productivity in the first year.


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