Why the ratio 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 (P/E) ratio. It indicates whether a stock is potentially overvalued or undervalued. Investors also consider 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 ratios on the stock market. Basically, the lower the P/E ratio, the cheaper and more attractive the share. Because P/E indicates how many years—with constant corporate profits—investors will receive the value they paid for the stock. 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 averaged a P/E value of 14 in recent years.

For comparison, the US index S&P 500 reached an average high of 30 last year. This shows how quickly stock market valuations fall due to high inflation. The S&P 500 has already fallen 40 percent since its peak last year, according to data from financial service Bloomberg.

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Calculate the P/E ratio for stocks

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. stock. Depending on whether an average rate or specific daily rates are used for the calculation, the 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 basis for calculation. The former is based on analysts’ forecasts and therefore tends to remain.

Generally speaking, since stock markets trade in the future, it makes more sense to look at expected earnings rather 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-to-earnings ratio of 321. Investors would therefore pay 321 times earnings for a Tesla share.

Amounts of this order quickly raise suspicions that the stock is overvalued. According to some analysts, this may also be the case in the case of Tesla. But this is exactly where you have to be careful.

Although the bare key figures seem off-putting at first, many analysts continue to 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 stock is not cheap at the moment.

What is a good P/E ratio?

A number taken by itself has insufficient meaning. 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 financial technology companies. In Germany, automakers such as 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 investor sentiment. In times of crisis like these, even a P/E of 14 can be seen 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, for decades, stock market giants like Warren Buffet followed the motto of making profits 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.

But since the company’s profits on paper can be easily adjusted using legal financing tricks – and thus the P/E ratio – well-founded profitability analyzes and company valuations are important for 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 ratios

As an alternative to the price-to-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 par with the P/E ratio. The former measures the ratio between the share price and the current book value per stock. The book value is the equity shown on 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 (PCV). Compared 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

Per P/E: Contra P/E:
Simple calculation Boiled profits and subjective analyst forecasts as influencing factors
Quick insight into potentially over- or undervalued shares No comparability across industries
No significance for companies with high investments and low profits

More: How Investors Evaluate Stocks: Five Measures of Stock Market Success

First release: September 3, 2021

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