What is a price-earn­ings ra­tio?

CityPress - - Business -

It helps to as­sess value

The price-earn­ings (PE) ra­tio is what in­vestors are will­ing to pay for a rand of earn­ings. To get the PE ra­tio, di­vide a com­pany’s share price by its earn­ings per share (EPS). Price means the ac­tual price of the share on the stock ex­change at a given point in time and rep­re­sents what in­vestors are will­ing to pay for that com­pany. EPS rep­re­sents the por­tion of the com­pany’s prof­its al­lo­cated to each share – the to­tal profit di­vided by the num­ber of shares in is­sue. If a com­pany’s share price is R120, and its EPS is R10, its PE will be R12. This means an in­vestor would be will­ing to pay R12 for R1 of earn­ings. It is im­por­tant to note that the PE is based on his­tor­i­cal earn­ings.

The con­cept of nor­mal earn­ings

One of the prob­lems with tak­ing a PE based on his­tor­i­cal earn­ings at face value is that prof­its can be cycli­cal. For ex­am­ple, a com­mod­ity com­pany that re­ported prof­its for the year end­ing six months ago would have earned these prof­its on com­mod­ity prices that are now, on av­er­age, 12 months old. If the com­mod­ity price has changed over the past 12 months, its cur­rent profit run rate could be much higher or lower than the last re­ported num­bers and the mar­ket will try to an­tic­i­pate this change in the share price. This ad­just­ment for an­tic­i­pated changes in earn­ings will ap­pear as a high or low PE.

So in­stead of us­ing ac­tual earn­ings, we pre­fer to as­sess the level of prof­itabil­ity and profit growth we think is sus­tain­able over time, which we re­fer to as “nor­malised” or “trend­line” earn­ings. This al­lows us to pick out two fac­tors in es­ti­mat­ing a share’s fun­da­men­tal value: our es­ti­mate of fu­ture earn­ings, and the price we would be pre­pared to pay for each rand of those earn­ings.

Ig­nor­ing the im­pact of short-term changes to profit, a higher PE ra­tio in­di­cates per­ceived bet­ter growth prospects, or less risk to prof­its, than the av­er­age com­pany. Thus, be­sides other fac­tors, a com­pany with a proven longterm track record of grow­ing prof­its will nor­mally trade at a high PE ra­tio and a com­pany with low growth, or a patchy profit history, will trade at a lower PE ra­tio.

Poor re­port­ing, trans­parency or gov­er­nance may af­fect in­vestors’ per­cep­tions of risk and so re­duce the PE ra­tio they are pre­pared to pay for earn­ings.

Con­text counts

We also con­sider PE ra­tios in con­text. First, we look at what other in­vest­ments are avail­able at the time. In­ter­est rates on cash are low and the prices of bonds and prop­erty funds are high. This might ex­plain why cur­rent PE ra­tios are also high.

Sec­ond, we con­sider at what PE we think we might be able to buy or sell a share in the fu­ture. The long-term history of the FTSE/JSE All Share In­dex (Alsi) is shown in Graph 1. The trend­line PE for the Alsi is 21x, which is well above the long-term av­er­age of 12x.

Hold­ing cash, even when it is not pay­ing very much in in­ter­est, lets us buy shares in the fu­ture when they re­turn to more nor­mal val­u­a­tions.

What can you do?

A “bal­anced” unit trust, where the in­vest­ment man­ager looks for the best value in­vest­ments across dif­fer­ent as­set classes on your be­half, can pro­vide you with some com­fort and pro­tec­tion from dra­matic fluc­tu­a­tions in re­turn. How­ever, in an en­vi­ron­ment of high prices, you should pre­pare your­self for less ex­cit­ing re­turns.

Newspapers in English

Newspapers from South Africa

© PressReader. All rights reserved.