Investing (like many noble professions) is a field in which many sometimes confusing acronyms and jargon abound. From dividends, yield, EPS and book value, there are a lot of odd-sounding words and phrases to get your head around.
One of said phrases is the 'P/E ratio'. This is one of the most quoted and yet most misunderstood terms in investing and has led many aspiring capitalists to run their financial ship aground.
So what exactly is the P/E ratio, and why is it so prolific in the world of share market investing? Those are the questions we hope to answer today.
What is the P/E ratio?
Well, as the name implies, it is a number that represents the ratio between a company's share price (P) and its earnings (E) or profits. Hence why the full name for the P/E ratio is the price-to-earnings ratio.
So, say if a company's share price is $100 and the company makes $10 of earnings per share, it would have a price-to-earnings ratio of 10 (100/10).
Put another way, it means that at a share price of $100, investors are willing to pay $10 for every $1 that a company makes in earnings.
Most companies have P/E ratios, but not all. If a company is yet to actually make a profit (like in the case of Afterpay Ltd (ASX: APT)), it will not be able to post a P/E ratio (as its earnings are less than zero).
What does the P/E ratio actually tell us?
A lot of beginner investors see the P/E ratio of a share as a simple measure of how cheap or expensive that share is. A dollar of earnings is a dollar of earnings, so if Company A's P/E is at 5 and Company B's is at 30, it tells us that the market is pricing Company B at a premium to Company A and is willing to pay a higher price for that same dollar.
Now, investors typically price a company higher if they think it is going to grow into a larger company in the following year and beyond, which would mean that $1 of earnings today per share is likely to turn into $2 per share tomorrow. Conversely, investors will probably fork out less if they don't think that dollar of earnings is going to grow in the future.
So what the P/E ratio really tells us is how the market actually views a company, not if its fundamentally overvalued or undervalued. It's a highly subjective metric. The market is not always perfect and can occasionally misprice shares.
Let's take a real-life example. Woolworths Group Ltd (ASX: WOW) and Coles Group Ltd (ASX: COL) operate in the same market and sell (pretty much) the same products – groceries. On current prices at the time of writing, Woolworths trades on a P/E ratio of 36.3, whilst Coles trades on 20.28. That tells us that the market thinks Woolworths is going to grow at a faster rate than Coles into the future.
Now that might happen, but it also might not. If it doesn't, you can probably expect to see the Woolworths share price fall and the Coles share price rise as these P/E ratios rebalance.
Foolish takeaway
The P/E ratio is a useful metric for analysing what the broader market thinks is going to happen with a company's stock price. But it is not a perfect indicator of whether a company is over-priced, fairly valued or under-priced. A lot of investors make a lot of money by going against what the market is thinking, so keep this in mind next time you see a low P/E ratio and think 'bargain'!
