Why the key figure is important for investors

Dax is currently performing close to its record high of over 16,000 points. High prices often give cause for concern about a bubble in the stock market.

In order not to invest in overvalued stocks, investors use various indicators as a guide. One of them is the price-to-earnings ratio (P / E). It indicates whether a stock is potentially overvalued or undervalued. Investors also take other parameters, such as return on sales or equity ratio, into account when choosing securities.

P / E: meaning and definition

The P / E ratio is one of the most important key figures in the stock market. Basically, the lower the P / E ratio, the cheaper and more attractive the stock is. Because P / E indicates how many years – with a constant corporate profit – investors will receive the value they have paid for the share. In other words: P / E measures the number of years in which the company would earn its current market capitalization.

The price-to-earnings ratio can be determined for individual stocks as well as for specific sectors or an entire market. For example, in recent years, Dax has had an average P / E ratio of 14. According to earnings estimates for 2021, the Dax P / E ratio should be 15.8.

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In September, however, the key figure was to increase as a result of the Dax expansion. Ten new companies will then move up to the leading German index – many index members are already predictable. Experts say that, among others, the aircraft manufacturer Airbus and the online fashion retailer Zalando have a safe rise.

Calculate the P / E ratio for shares

The formula for the share-earnings ratio follows a simple principle: a company’s share price is set in relation to its earnings per share. shares. Depending on whether an average rate or specific day rates are used for the calculation, P / E may vary.

On the profit side, the price-earnings ratio can look into the future. In this way, profit estimates for future accounting periods can be used as a calculation basis. The former is based on analysts’ forecasts and therefore tends to remain.

In general, as stock markets trade in the future, it makes more sense to look at expected earnings than past profits. The latter serves more for historical comparison.

How to calculate P / E example Tesla

On July 26, Tesla presented its Q2 202 quarterly results. CEO Elon Musk’s company reported record earnings per share of $ 1.02 (USD). After the market closed, the stock traded at $ 557.10. That equates to a price-to-earnings ratio of 546.18. Investors would therefore pay 546 times the earnings for a Tesla share.

Sizes of this order quickly raise suspicions that the stock is overvalued. According to some analysts, this may also be the case in Tesla’s case. But it is precisely here that one must be careful.

Although the bare key figure initially seems daunting, many analysts assume that the company has strong growth and profit prospects. Whether the high rating is justified or not will inevitably only become apparent in the future. However, Tesla shares are not cheap at the moment.

What is a good P / E ratio?

A figure taken for himself has insufficient significance. This also applies to P / E. The latter should not only be considered as a complement to other key figures in a company, but above all in its historical development and in the context of the industry. A good P / E value cannot be generalized.

Representatives of the pharmaceutical industry have fundamentally different price-earnings ratios than companies in the field of financial technology. In Germany, car manufacturers around Volkswagen and Daimler are among the leaders, mostly with single-digit P / E ratios. Measured at a price-to-earnings ratio of around 26, Apple and Alphabet are the cheapest among the major technologies.

Whether a P / E is considered cheap also depends on the mood of investors. In times of crisis, even a P / E of 14 can be perceived as expensive.

Investment strategies based on P / E

There is no doubt: it is not enough to focus an entire investment strategy on a single key figure. Nevertheless, stock market giants like Warren Buffet for decades followed the motto of making a profit by buying cheap stocks – the stocks usually had a P / E ratio of less than 15.

In addition, the majority of the shares were characterized by a high dividend. The combination of low P / E and high yield should limit any potential losses during economic downturns.

However, as the company’s profits on paper can be easily adjusted using legal financing tricks – and thus also the P / E ratio – well-founded profitability analyzes and company assessments are important for the long-term stock market success.

The price-earnings ratio remains a key figure with limited significance – and should always be supplemented with additional sizes.

P / E in contrast to other key figures

As an alternative to the price-earnings ratio, the price-to-sales ratio (PVR) can be determined by relating a company’s market value to its annual sales. The calculation is useful if a company is not yet profitable and does not make a profit.

The price-to-book ratio (P / BV), on the other hand, is on a par with the P / E ratio. The former measures the relationship between the share price and the current book value per share. shares. The book value is the equity shown in the balance sheet. Again, the higher the price-to-book ratio, the higher the stock’s valuation.

Finally, investors can also calculate the price-to-cash flow ratio (KCV). Compared with the P / E ratio, the liquidity-oriented indicator has the advantage that a company’s (operating) cash flow is much more objective than its profit.

Advantages and disadvantages of KGV in the overview

Pr. P / E: Contraindications P / E:
Simple calculation Boiled profits and subjective analyst forecasts as influencing factors
Quick insight into potentially overvalued or undervalued stocks No comparability across industries
No significance for companies with high investments and low profits

More: How Investors Rate Equities: Five Measures of Stock Market Success

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