The importance of valuations

Alice Browne
29 Jul 2019

The importance of valuations

Investors can use a number of different technical measures to value companies and then assess whether they currently offer good buying or selling opportunities. However, as each measure has its own strengths and weaknesses, it’s important that the valuation method you do use is relevant for the type of company you are valuing.

One of the most commonly used valuation measures used by industry analysts and investors is the price-to-earnings ratio (or P/E ratio).

What is P/E ratio?

It is an expression of how expensive or cheap the shares of a company are, relative to the profits it generates. The P/E ratio indicates the dollar amount an investor can expect to pay to invest in a company, in order to receive one dollar of that company’s earnings. For example, if a company is currently trading on a P/E ratio of 15, it suggests investors are willing to pay $15 for $1 of the company’s earnings. To determine the P/E ratio, we divide the company’s current share price by its earnings per share (EPS).

P/E ratio = current share price ÷ earnings per share

The current share price can be easily located on the ASX website, however, the EPS is a slightly more nebulous figure.

Earnings per share is typically a company's net profit divided by the number of shares it has on issue. EPS effectively shows how much money a company makes for each share.

You can use either the company’s historical EPS over the past 12 months (hence providing a ‘trailing P/E ratio’) or future EPS guidance from company earnings reports or analyst estimates (hence providing a ‘forward P/E ratio’). Remembering that a company’s past performance doesn’t necessarily signal future behaviour, investors are typically more interested in future earnings power, preferring to use the forward P/E ratio.

How to use the price-to-earnings ratio

A company’s P/E ratio isn’t particularly helpful in isolation as there is no rule of thumb for assessment. However, it proves more meaningful in assessing whether a company is currently overvalued or undervalued when compared to its own history. It also allows an investor to compare one company against others operating in a similar sector, as well as the overall share market index.

By looking at an example, if Commonwealth Bank Limited (CBA) was trading on a P/E ratio of 14.5 times, it tells us very little in isolation. However, in the context of CBA’s 10-year average P/E ratio of 13.7 times, the financials sector P/E ratio of 13.4 times and the ASX200 P/E ratio of 16.2 times, we can say that CBA is more expensive than it has been in the past on average, more expensive than similar companies in the financial industry, but less expensive than the overall Australian share market.

In addition to comparing the relative value of a company, the P/E ratio can be used to compare different sectors and share markets against one another, or over time. This can help investors determine whether it is a good time to be investing in Australia, the US, Europe or Asia.

"Some industry sectors which are particularly subject to rapidly evolving innovation...have historically traded on high P/E ratios."

Does a high P/E ratio mean a company is expensive?

A high P/E ratio could mean that a stock's price is high, relative to earnings and is therefore possibly overvalued. However, in general terms, a high P/E ratio suggests investors are expecting higher earnings growth in the future or that a company has reliable earnings.

This is why some industry sectors which are particularly subject to rapidly evolving innovation, such as healthcare and information technology, have historically traded on high P/E ratios. It suggests that investors are willing to pay more for these companies today in the expectation of receiving increasing earnings in the future, which also correlates to their perceived growth prospects.

Some companies may also trade on higher P/E ratios because they have relatively stable earnings, and investors are willing to pay higher prices for this certainty.

Conversely, a low P/E ratio might indicate that the current stock price is low relative to earnings and possibly undervalued. However, the P/E ratio could also be being impacted by perceived sector specific or stock-specific risks, including investor sentiment.

Key considerations when comparing P/E ratios

One shortcoming of using the P/E ratio emerges if you are comparing companies in different sectors. The growth rates, industry dynamics and risks to earnings will vary wildly between sectors. For example, comparing the P/E ratios of a telecommunications company versus an energy company may lead you to believe one is clearly the superior investment, but this is not a reliable assumption due to the differing sectors.  

When looking at P/E ratios, you also need to consider what stage the company is in its life cycle, relative to others in the same sector. For example, start-up and newer companies with high growth prospects can commonly have very high P/E ratios, because although their current earnings may be small as they spend money to grow, they have the potential to become significantly more profitable in the future.

The P/E ratio is most suitable to use when a company has relatively stable earnings and there are other comparable companies in the local share market.

When making investment decisions, there is usually a lot of information available from industry analysts, including P/E ratios. P/E ratios should not be used as a stand-alone decision-making tool, however by understanding how P/E ratios are used when determining whether or not a stock is currently offering good value, investors can interpret some of this information to assist with their decision.

Eager for more?

You can watch Alice’s presentation on The importance of valuations from the Evans Dixon Wise Summit in May 2019 here. During this presentation, Alice explains two metrics which are commonly used by investors and their advisers to determine the value of an investment and whether there is a good buying opportunity or not, the first of which is the P/E ratio.

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