What is a Price-to-Earnings ratio?
The Price-to-Earnings (P/E) ratio calculates the price of a company as a multiple of that company’s earnings. You can calculate it for yourself relatively easily on a per-share basis, using the below equation.
P/E ratio = Price per share / Earnings per share
As an example, if the price of “Fantastic Company” is $100 per share, and it earns $10 in its most recent financial year, “Fantastic Company” would have a P/E ratio of 10x.
In a way, we can translate the P/E ratio into plain english as the answer to the question “if the company keeps earning the same amount that it did in this past year, how many years before I get all my money back, assuming it pays out all its earnings in the form of dividends”.
But we made 2 huge assumptions there: 1) earnings stay the same in future, and 2) all earnings are paid out as dividends. This isn’t really how the world works, so you would be forgiven for concluding the P/E ratio is an unrealistic number, and asking what all the fuss is about!
So, what IS all the fuss about?
The P/E ratio is something many investors look at simply because it’s usually a readily available (ie. Google-will-know) number which you can then take and compare with the P/E of lots of other different companies - it’s useful mostly as a comparison tool between companies.
2 similar companies should have similar P/E ratios, and by that line of reasoning, if you find a company with a much higher P/E ratio compared to its peers, you might conclude that it is overvalued compared to its “cheaper” peers.
Before you run off to buy the lowest P/E stocks you can get your hands on, a word of warning - highlighted by looking at everyone’s favourite streaming service - Netflix 🎞.
Over the last 5 years, Netflix’s P/E ratio has ranged from 80x to 400x. Compare that everyone’s favourite movie maker Disney, who has seen its P/E ratio floating between 10x and 20x. On the face of it, these two companies aren’t so different, right? Disney probably owns better media (think Marvel and every other great movie from your childhood) and it even released its own streaming service recently!
So why the huge difference in P/E ratios for two companies who are not-too-different? Well, Netflix still has enormous potential for growth across the world - its earnings per share are expected to grow a lot in the next few years, which means that its P/E ratio should become more “normal” over time. In contrast, while Disney doesn’t do so bad for itself, its growth potential is *probably* not as high as that of Netflix when you take into account all the weird and wonderful shows that Netflix is coming out with across the world these days.
You’d need to dig deeper into the numbers to really figure out whether Disney (maybe undervalued) is worth buying over Netflix (maybe overvalued), and it’s something you’ll find a lot of recent articles about as the investment industry has been wrestling with the same question too!
The P/E ratio is far from perfect and not the only thing to look at when thinking about investing in a company - but it is one of the most readily available ratios for companies as well as whole stock indices and one worth keeping an eye on!
Note: Disney / Netflix P/E ratios sourced from Macrotrends.net
Please know, the value of investments can go up as well as down and you may receive back less than your original investment, meaning, when investing your capital is at risk.
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