When it comes to fundamental analysis Price-Earning Ratio is a important indicator of whether a stock is over or under valued. To calculate the Price-Earning Ratio (P/E) of the stock, you take the Share price of that company and divide it by the company full year earnings per share (EPS). Once worked out the Price-Earning Ratio is an indicator of how expensive that companies shares are for every £1 of profit that the company makes.
Taken quite generally the higher the P/E the more expensive the company’s shares price is. And also taken quite generally the lower the P/E the cheaper the companies share price is. Though there are other factors also in play. One should be suspicious of companies that have extremely high or low P/E ratios.
The Price-Earning Ratio’s you work out during your fundamental analysis only have meaning when used to compare different companies within the same sector. For example you want to consider one companies P/E ratio compared with one of its direct competitors or with an average of companies from that sector.
If there a two Banks in direct competition one is called Big Bank PLC and the other is Underdog Banking Corporation. Big Bank PLC has a P/E ratio of 15, while Underdog Banking Corporation has a P/E ratio of 7. The shares in Underdog Banking Corporation are cheaper in regard to the amount of profit made in comparison to the overall share price. If we were then to work out that the the average P/E in the banking sector was around 9, you may be able to determine that Big Bank PLC shares are significantly overvalued while Underdog Banking Corporation is slightly undervalued. You have to make sure what you are comparing is really comparable to one another, otherwise your P/E analysis won’t be accurate.
If your using the most update to EPS (Earning Per Share) data then when you work out the P/E ratio, you are working out the historic P/E ratio. But if you use the forecast earnings (worked out by analysts, be careful forecast earning will not always be correct) to work out at your P/E ratios you are working out the prospective or forward P/E ratio.
Working out the P/E ratio is as easy as ABC, so I’m going to put up a quick a example, to work out the historic P/E ratio of the National Dog Walkers Corporation you would do the following. You take the share price of 500p per share and divide it by the previous years earnings of 50p a share.
500p/ 50p = Historic Price Ratio of 10
But now we want to work out the prospective or forward P/E ratio, again we take the 500p share price and a take an analysts projection of earnings per share of 35p share. Again it’s just a simple calculation.
500p/ 35p = Forward/Prospective Price Ratio of 14.28
As you can see the relative to earnings value of the company has become more expensive, but this analysis is only really valuable when compared to other comparable companies.
Part of the Beginners Guide to Strategy and Analysis for Spread Betting