Precisely at the beginning of the current reporting season (in this phase the companies present their balance sheet from the previous year or current quarterly figures) I would like to present the two most important key figures regarding the current share price in relation to the company’s profit.
The price-earnings ratio (P/E)
The price-earnings ratio (P/E) is probably the most frequently used criterion when evaluating shares. It shows you the multiple of the annual profit at which a company is valued on the stock exchange. The benchmark for a cheap P/E ratio is 10, the market average is around 15.
A low P/E is seen in isolation, but is not necessarily a reason to buy. If the future earnings prospects are poor or if the debt is too high (balance sheet problems), the stock has little upside potential. Here is the formula you can use to calculate the price/earnings ratio: The profit can refer to already determined profits or to expected profits.
In stock analysis, which almost always looks at estimates for the future, the P/E ratio plays a big role. However, the P/E ratio is not without controversy among experts. The reason: the annual profit, i.e. the basis for the calculation, can be steered in the desired direction by the company.
Legal accounting tricks can be used by management to affect net income. In particular, provisions and depreciation are often used for “fine-tuning” to achieve the desired result. P/E should therefore always be treated with a degree of caution.
You should also note that profits cannot simply be carried forward. The effects of internal changes must also be taken into account, such as cyclical fluctuations and changes in competition or consumer behaviour.
Interest rates and changing product life cycles can also play a role. In some sectors there are also completely unpredictable factors such as the weather and political decisions.
Calculation example Ebay
The American company Ebay this week published its figures for the financial year 2012. Let’s see how the P/E ratio looks like: P/E ratio with 2012 earnings per share. share at $1.99 and current price at $52:
52: 1.99 = 26.13
Next, let’s look at how the current P/E ratio looks given the current price and Ebay’s estimated 2013 earnings per share. stock: P/E calculation using estimated 2013 earnings: Ebay expects earnings per share for fiscal year 2013 will be up to $2.75.
At the current price of around USD 52, the calculation in the optimistic scenario looks like this: P/E (assuming earnings per share of USD 2.75)
52: 2.75 = 18.91
If we use eBay’s 2013 earnings forecast of $2.75 per share as a basis of calculation, the 2013 P/E is 18.91. This makes Ebay stock slightly more expensive than the overall market.
Advantages and disadvantages of both calculation alternatives
A disadvantage of calculating P/E using last year’s earnings is that it is essentially out of date. A major advantage of this calculation, however, is that the profit is fixed, as it is not “just” a forecast. The disadvantage of the calculation taking into account the expected profit is that it is “only” a forecast.
As already mentioned, strong downward and upward deviations are sometimes conceivable. I have already described possible influencing factors for this. The advantage of this analysis is that it takes into account the current earnings development, which is more important for the share price than the previous year’s result.
My tip: look at both P/E values. Then you have 2 reference points for the question of whether the share is expensive or cheap.
Price-earnings relative to growth (PEG)
An extension of the P/E ratio is the price-earnings-growth (PEG) ratio. This ratio is also known in German as the price-earnings-growth ratio. The indicator sets the P/E ratio in relation to the expected earnings growth.
As a rule of thumb, the PEG is cheap if the P/E is at most as high as the expected earnings growth. If P/E and earnings growth are identical, PEG is 1.
The rationale here is that if a company increases its profits by double digits per year, it can also be valued higher than a company that only slightly increases its profits. The rule of thumb is: A company that regularly increases its profits by 30% per year can also have a visually high PER of 30. If the company is growing slowly, the P/E should be lower.
Conclusion: P/E and PEG will help you value stocks independently in the future
Both metrics have advantages and disadvantages. However, as already mentioned, these are the two most important key figures in connection with the share price and the company’s result. If you are familiar with these two key figures, you have a good initial basis for being able to assess your shares yourself in the future.