The broader meaning of P/E
Question: Can you expound on the meaning of P/E when it comes to stock market investing?—asked at “Ask a friend, ask Efren” free service available at www.personalfinance.ph and Facebook.
Answer: The traditional meaning of P/E is price divided by a company’s earnings per share (EPS). “Price” refers to the peso level of a company’s shares at the stock exchange, known as the market price/value. The term “earnings” refers to the company’s net income as of a certain date divided by the total number of stockholders also as of the same date.
In layman’s terms, P/E refers to the price per share that investors are willing to pay at a particular point in time for each share of a company, given the net earnings that each share would have been (on a historical basis) or could be (on a prospective basis) theoretically entitled to.
If the market price was P10 and the historical EPS was P1, the P/E ratio would be 10 times (i.e. 10 ÷ 1). If you invert the ratio to E/P, what you get is a return on investment formula with an answer of 0.10 or 10 percent (i.e. 1 ÷ 10) on an absolute basis (i.e. without consideration for time value of money).
I used the phrase theoretical entitlement because not all of the earnings of a company are paid to its shareholders in the form of cash dividends. In fact, for a growing company, most of the earnings will be reinvested with little or no cash dividends paid out. Before you cry unfair, a company’s management will only reinvest earnings if it sees a potential for growing earnings further. Higher earnings could potentially translate to higher dividends and a higher market price. Selling at a higher market price would translate to capital gains for the shareholder.
Why will higher earnings lead to a higher market price? Would not the higher market price just lead to a lower P/E ratio? Not always. Investors develop an informal consensus on the P/E level that each stock deserves. With EPS moving up, market price will also have to move up just to maintain the consensus P/E, hence the potential for capital gains.
But there is a broader meaning of P/E and that is planning with execution. Allow me to expound.
The analysis of the price/earnings ratio is but a small part of the larger job of personal financial planning. Personal financial planning encompasses the following:
- Balancing out the required returns needed for achieving goals with the investment risks that a person is willing to take. The return-risk tradeoff is influenced by a person’s investment horizon, amount of starting investment, size and frequency of periodic additional investments, and the quantified future value of goals.
- Performing step 1 separately for each major goal.
- Uncovering that financial security that matches the return-risk tradeoff of the investor. A return target of 10 percent a year compounded or higher means that stocks should be part of the investment portfolio. The closer the required return is to 20 percent a year compounded, the higher should be the allocation to stocks in the investment portfolio (and necessarily the higher the risk that needs to be taken).
- Fine tuning the allocation or weight applied to each component investment of the portfolio until the overall portfolio return-risk trade off matches that of the investor. This means fundamental analysis has to be done on companies in the radar of the investor. Fundamental analysis is the in-depth review of a business’ financial performance and condition, its competitors and its markets, with traditional P/E analysis included.
Execution
They say people only fail to plan and not plan to fail. But failing to execute a plan is just as bad as failing to plan.
Yet, (Philippine) history has shown that executing a plan by merely buying and holding stocks is also not the most effective method.
No stock price will move in a straight line. And in markets that are considered not efficient (as defined by the efficient market hypothesis), stock prices will gyrate in a channel (the width of which is determined by how risky investing in the company is).
While a financially promising company may have gyrations within a generally upward trending channel, it is not unthinkable to have stock prices gyrate within a long and wide sideways trending or even downward trending channel (particularly with the presence of overwhelming global developments).
Regardless of the direction, volatility is here to stay. And to take advantage of this volatility, investors must engage in stock trading, with buy and sell signals dictated by their derived return-risk trade off and the established trading bands of individual stocks. This is where technical charting proves to be of great importance. Technical charting, the full discussion of which is the stuff for books, ranges from the use of complex algorithms to simple historical upper and lower price bands.
So when investing, do not focus on the traditional P/E as that is but a small part of planning. Do not also focus too much on the execution through trading as that is but one-half of the task at hand. You will need to combine both planning and execution to cover the broader meaning of P/E.
If you want to know a bit more about the broader meaning of P/E, avail yourself of our free tools at www.personalfinance.ph. You may also want to attend our various training programs, details of which are at www.personalfinance.ph/fptraining.html.
(Efren Ll. Cruz is a Registered Financial Planner of RFP Philippines, personal finance coach, seasoned investment adviser and bestselling author. Questions about the article may be sent by SMS to 0917-505-0709 or e-mailed to [email protected]. Attend free personal finance talk on April 13, 7pm at PSE Center. For more details, inquire at [email protected] or text <name><email><RFP> at 0917-9689774.)
