It is amazing how so many industries choose to hide behind their own jargon and acronyms. In IT, audio, and even the car industry – they all use terminology that makes them sound like experts in their own field but often fails to communicate with their customers.
Are we really expected to know what MBS, a signal to noise ratio or a VTEC system means?
(When I worked in with a large insurance company, I started a movement called "Axe the Acronym". You can imagine how well that went!)
The share market can be just as mystifying. So here, I will try to simplify and explain what one important term really means and more importantly, its significance to you as an investor.
So what is a P/E ratio?
The ubiquitous Price to Earnings Ratio – everyone talks about it – but how many people really understand its significance?
In the analysis of a company's financial state of health, its P/E ratio could be compared to the health of its blood system. The ratio can be arrived at by dividing a company's market capitalisation (that is, its share price multiplied by the number of shares issued) by its annual net profit.
In other words, if each share is $10 and there are 100 million shares issued, its market capitalisation is $1 billion. And, if the company's annual net profit is $50 million, its price to earnings ratio would be 20. If it showed a net profit of $200 million, its P/E ratio would be 5. Getting the picture?
Actual average ratio for the Australian stock market can vary between a low figure of 8 after a market crash up to around 25 in boom times.
Some revealing examples
As I said, a company's P/E ratio is like the results of a medical. For example, National Australia Bank Ltd. (ASX: NAB) currently has a P/E ratio of around 13, while the Commonwealth Bank of Australia (ASX: CBA) has a higher P/E ratio of roughly 16. While these two big ASX banks are recording different results, the numbers place them both in the normal range.
In contrast, a share like Medical Developments International Ltd (ASX: MVP) has a huge P/E Ratio of around 520, yet its share price has more than doubled in the past 12 months! This illustrates that the P/E ratio is only one of the many factors you should study to determine your investment choices.
As always, it pays to be thorough.
Beware of smoke and mirrors
Of course, the honesty of some companies' profit declarations could be an issue and can grossly distort their P/E ratio. 'Clever' accounting can be employed to falsely inflate net profits. Close scrutiny of the company's balance sheet should reveal any chicanery. A key factor is whether the company's cash flow supports its profitability claims.
Once you've established an accurate P/E ratio, it can be a very valuable tool. The ratio is a gauge of market sentiment including general views of the company's quality of management, prospective profitability and other measures that contribute to an overall picture of its worth.
You can even study charts that plot a company's historic P/E performance and any sudden shifts should be viewed with suspicion.
A company's P/E ratio really does matter if you are looking for shares that have broad support with a set of hard financial facts to underpin their popularity amongst the investors.
