Price Earnings Ratio: A Guide for Investors

If you are new in investing in the stock market it is easy to be amused how relatively easy it is to make a profit “buy a company when its stock price is low and sell when prices go up”. So as common sense suggests, the most important question to ask yourself when you are planning to invest in the stock market is the timing of your entry to the market when a company’s stock price is considered as “cheap”.

There are many ways to determine the optimal price for a company but the most commonly used valuation metric by investors is the price to earnings ratio (P/E). It is considered powerful metric yet very simple in determining whether a company’s stock price is cheap or expensive at current prices. P/E is short for the ratio of a company’s share price to its per-share earnings.

As the formula suggests, there are two factors in computing the P/E Ratio namely (1) the current market value of a company and (2) the company’s net income. In general a high P/E ratio suggests that the company’s stock price is expensive and a low P/E ratio suggests that the company is cheap.

To illustrate, a glance at the Philippine Stock Exchange Composite Index (PSEi) composed of the top companies in the Philippines with their market price, earnings per share, and P/E Ratio as of June 2012 is shown below:

Accordingly, the top three companies per Market Price and Earnings per share (EPS) are PLDT (TEL), Globe (GLO), and SM investments Corporation (SM). However, surprisingly the top three companies with the highest P/E are Petron Corporation (PCOR), Belle Corporation (BEL), and Jollibee Food Corporation (JFC).

On its face it can be said that PCOR, BEL, and JFC are the most expensive stocks and should be avoided by investors because of it’s high P/E ratio. However, since the stock market is composed of millions of individuals who think and rationalize differently this is all common. Therefore, I classified the two factors (price and earnings) and analyze how investors justify a low or high P/E per share:

Class  I: high price but low earnings – these companies have experienced great growth in their stock prices over the years but are currently experiencing earnings decline because of stiffer competition or maturity in their market share  (e.g. beer manufacturer with established brand but with limited earnings growth)

Class II: high price and high earnings – it suggests that investors forsee that the current prosperity of a company would continue in the foreseeable future (e.g. profitable bank with efficient operations and good corporate governance)

Class III: low price and high earnings – this is usually the case for companies that have taken a hit due to negative publicity, earnings miss, resignation of key management personnel, labor strike, and the like but it’s earning capacity is still intact despite this temporary problems (e.g. utility company losing on a public bidding)

Class IV: low price and low earnings – investors who choose these stocks gamble on the hope that a significant increase in the company’s earnings would occur in the future and consequently its stock price as well (e.g. a mining or oil company’s sudden discovery of gold or oil reserves from their exploration)

Therefore, we can surmise that PCOR and BEL belongs to Class IV and JFC relatively belongs to Class II. So if your expecting PCOR and BEL to make a recovery or sudden increase in their earnings and JFC to maintain their standard of excellence you may still put your money with them even with a high P/E rate.

Theoretically, a stock’s P/E tells us how much investors are willing to pay a peso for a company’s earnings. However, valuation of stocks involves subjectivity. A person X may assign a higher P/E multiple to the stock as compared to person Y depending on a person’s risk profile and growth expectations, and the market’s historical performance and sectoral characteristics. What is important to an investor, therefore, is to do your research and find the companies with the best “value”.

As Benjamin Franklin said: “The market is a ‘voting’ machine wherein countless individuals register choices that are product partly of reason and partly of emotion. However, in the long-term, the market is a ‘weighing’ machine on which the value of each issue (business) is recorded by an exact and impersonal mechanism”.

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