P / E – please do not rely on this metric when analyzing stocks

What does P / E say?

You can easily calculate P / E by dividing the current share price by earnings per share. share (EPS). The price-to-earnings ratio indicates how many times the profit of a share is currently valued at. Simply put, P / E shows how many years a company needs to post the current annual earnings to earn its market value. The smaller the key figure, the cheaper a company appears at first glance.

You can quickly find the current course. Earnings figures, on the other hand, are based on either last year’s earnings or (in most cases) an analyst estimate for the current year. This must take into account the expected earnings development, which has already been priced into the current share prices. The P / E analysis also applies: “The future is traded on the stock exchange”.

The P / E ratio is easy to manipulate

Earnings expectations can be misleading, as analyst estimates are subject to great uncertainty – especially at the beginning of a new financial year or in specific market phases, most recently in the context of the Covid-10 crisis. Reliable but not very meaningful P / E analyzes are only possible on the basis of historical data.

Another point is that the P / E ratio is easy to manipulate. The annual result is calculated after tax, depreciation and financing costs. Companies can to a certain extent control these factors in their accounts and thereby distort the comparability between companies. This sensitivity to a company’s accounting policies is considered as one of the main weaknesses of the indicator.

There is no reliable rule of thumb regarding the P / E ratio that a company is “reasonably valued by”. P / E ratios can vary greatly depending on the market phase and industry. High double-digit P / E ratios are not an exclusion criterion, eg if the company achieves high earnings growth. On the other hand, a low price-to-earnings ratio is also no guarantee: if stock prices fall due to negative earnings prospects, a P / E ratio can be optically misleading.

I will now show you what key figures to add to your next stock valuation.

You add these key figures to the evaluation

A P / E assessment only makes sense for companies within one industry, as tax and accounting practices are basically the same here. As mentioned above, high P / E ratios can also be justified by corresponding earnings growth. To take this factor into account in the stock valuation, the P / E ratio was further developed to PEG (Price / Earnings-Growth-Ratio). PEG relates the P / E ratio to annual earnings growth. If both ratios are the same, a fair assessment is assumed.

Logically, stocks are considered overvalued when they have a PEG greater than one. You can also calculate price-to-sales (P / S) ratios for high-growth, non-profit companies. Sales are less susceptible to manipulation. The same is true here: A price-to-value ratio under one indicates that the company is undervalued.

Another metric I personally often include in my reviews is price-book ratio (P / B). KBV sets the market value in relation to equity. The lower a price-to-book ratio, the cheaper a stock is. Volkswagen has a current market value of 153 billion euros. Pr. At 31 December 2020, equity was EUR 113 billion. The Volkswagen share is therefore valued at a price-to-book ratio of 1.35, which currently seems relatively reasonable.

Finally, you can add the solvency to these ratios. This gives you a good indication of how stable the balance is. It indicates which part of the balance sheet total – as the total capital of a company – is to be allocated to the shareholders. The higher the metric, the better. A rule of thumb says that companies with a solvency of over 30 percent are considered to be solidly funded. But again, lower values ​​are acceptable if a business has a reliable flow of cash.

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Conclusion

Never rely on individual ratios when making investment decisions. Each company is unique, so a P / E ratio has a different meaning for each company. To refine your KPI analysis, you should always use other metrics to assess a company’s growth, stability and management.

Today, P / E is only suitable as an indication of over- or underestimation, nothing more. Therefore, a pure P / E analysis is not enough to find the right company.

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