A beginner's guide to p/e ratios - MoneyWeek Investment Tutorials

so what our price earnings ratio is all about you hear them a lot you see them a lot they are mentioned on analyst reports in the FT or Bloomberg terminals and websites such as digital look of course money week uses p/e ratios all time but only actually me and how people use them well the good news is although we're going to run through our calculation in a moment you'll probably never have to normally they're done for you and use the end results but to really understand what I PE ratio is all about you need to see a little bit of what's under the bonnet so why would we use a p/e ratio in short as an investor we want cheap shares we don't want rubbish we want quality companies or want them at a decent price and that's their way to find a cheap company there is the p/e ratio is one way of doing it's not the only way but it's a popular way so the objective is to use a p/e ratio to determine whether a company's cheap or expensive so let's take a look at the calculation what is the P for me in short the P is a company's share price so we could start with the price per share for a company such as a food retailer so we can start with pesco and at the moment the Tesco share price is four pounds plenty now the question we're asking is do I want to buy a Tesco at 4 pounds 20 is that too much is that a bargain I don't know price earnings ratios are one way of finding out so let's compare the share price to something and what the price earnings ratio compares it to is what's called earnings per share as an accounting number it's something you can pick up from a set of accounts and it represents one year normally the last 12 months earnings that's profits per share so I have them - no but the Tesco at the moment that's the rate on Fletcher B so I've got today's share price I'll change tomorrow next week compared to one year's earnings on a per share basis because this is one share so this needs to be expressed per share as well so we're not comparing apples and pears if you like and that gives a number the result if you like is around 14 or 14 times it's just a number or while analysts sometimes call it multiple so another word is the p/e multiple so what we're saying is there is a number called the p/e ratio but looks at the share price in earnings terms in other words if you pay four pounds 20 to buy Tesco right now you are paying 14 times one year's earnings to get it as though the question is does that mean you should buy it or not difficult question to answer you could look at just Tesco by yourself you could say well what's this time be just tells me that if I buy 4 pounds 20 an earnings don't change it will take 14 years just to get my forecast Winky make anything what I wait 14 years probably not most investors wait no more than three or five so how can I tell if Tesco is a bargain well the answer is comparator something so protect away the calculation what we could do is take that number fourteen and look around for something to comparative so let's take the Tesco price earnings ratio and hunt around for something to compare it to so we've got Tesco trading on a p/e ratio 14 an obvious thing would be to ask is that cheaper expensive in relation to say Sainsbury's one of their biggest competitors so let's imagine we look up the Sainsbury's p/e ratio and we find that it's 30 so now we know that Tesco trades on the p/e of 40 and Sainsbury's is a little bit cheaper on 30 but still I'm torn between the two so it's going to take you 13 years to get my money back if I'm best for Sainsbury's than 14 years with Tesco so maybe I need to do a bit more work before I decide whether I'd buy a Tesco or whether I buy either maybe what I could do is look at the sector so I could look up in the FT or on Bloomberg I could look out the food retailing sector you get the right one and let's say that that's trading on a p/e multiple 60 so suddenly I'm thinking will these two supermarkets big brand names look relatively cheap compared to the sector and Sainsbury's is log achievement faster so now I want to ask the question why is there a reason why Sainsbury's and Tesco are a little bit cheaper than the sector average what's happening to suggest that these two should play on their multiples it could be that they're a bargain that's what I'm looking for but I need to be careful because maybe there's something going on maybe senior directors I thinking about leaving these two supermarkets perhaps there's some kind of price war going on in their part of the market perhaps one of them is struggling to expand overseas Tesco for example as hip problems in America so I need to look for some more information then that told you one of the limitations about p/e ratios by themselves even when you've got something to compare them to they can be dangerous you need to understand why a company's cheap is it a bargain or is there a problem factored into the share price I could go further though these are listed one footsie 100 companies so maybe where I want to do is say well ok they look cheap in relation to the sector but then I even looking in the right part of the market for cheap shares so practically I should do is just take a look after why the market so I could look up the footsie 100 these companies have both members of that Club the top 100 companies in the UK but yeah these are looking cheap relative to the rest of the market so the key with ratios all ratios not just opinion multiple is to hunt around for something to compare them to by themselves or a little bit dangerous once you've got the comparison then you can start to ask the question do I think one of these companies is cheap on which one role to buy how I compete your ratios go is 17 high is 49 well supposing I designed a online clothing retailer or boo calm its model allows you to size yourself up on the internet look at yourself as a kind of dress mannequin and n1 of the clothes you see and let's say food or food or comma a technology company as a pH no 100 what does that mean does anymore away 100 years as a shareholder just to get their money back no you might wait 10 you might wait 14 and test goes on we might make 20 probably you don't and usually they wait a hundred so what's going on is this a nonsense figure no it isn't because if we think about what that multiple represented it was the share price as a multiple hundred times earnings oh sure so essence that does tell you something it says if your pets pay a hundred times one year's earnings per share to buy a company like this of technology company you must be expecting something pretty spectacular what happened here you must be expecting very fast earnings growth otherwise why on earth would you pay 100 times one year's earnings for the share you're not going to wait a hundred years you only going to wait 50 years and the only way you're not going to be waiting that at the time is if earnings rocket that's the point a lot of high technology companies are expected to produce big earnings very quickly they're expected to expand fast and they're expected to deliver an increase in earnings fast so people will sometimes pay what seem like crazy multiples but frankly it's a gamble so as a rule of thumb the lower the p/e ratio the better your chances of making a return and that's why is a rule of thumb if there's no reason why PE ratio is below there are problems with the company you'd always prefer a low p/e multiple to a crazy one like that and a good starting point is always the UK market

Channel: MoneyWeek

Views: 130,409

Keywords: educational, finance, pe, ratio, tim, bennett, moneyweek, investment

Id: zAtMjVUnXkM

Length: 9min 41sec (581 seconds)

Published: Fri Mar 11 2011