Why the key figure is important for investors

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 into account other parameters such as return on sales or equity ratio 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 stock market value.

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

By comparison, the US S&P 500 peaked at an average of 30. Last year, it shows how fast stock market valuations are falling due to high inflation. The S&P 500 has already fallen 40 percent since its peak last year, according to data from the financial service Bloomberg.

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Calculate the P / E ratio for shares

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

On the profit side, the price-earnings ratio may 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 April 20, Tesla presented quarterly results for Q1 2022. CEO Elon Musk’s company reported record earnings per share of $ 2.86 (USD). After the market closed, the stock traded at $ 918. This results in a price earnings of 321. Investors would therefore pay 321 times the profit 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 with Tesla. But it is precisely here that one must be careful.

Although the bare key figure initially seems daunting, many analysts still 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 number taken for granted has insufficient significance. This also applies to P / E. The latter should not only be considered as a supplement 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 such as the Mercedes-Benz Group are among the leaders, mostly with single-digit P / E ratios.

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Whether a P / E is considered cheap also depends on the mood of investors. In times of crisis like these, 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 of limited importance – 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). In relation to 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

First release: September 3, 2021

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