Investor Education Series: Using P/E Ratios to Evaluate Shares or Markets

Investor Education Series: Using P/E Ratios to Evaluate Shares or Markets

P/E ratios are used extensively as a quick evaluation tool. It is probably the most used tool to value shares or markets as cheap or expensive. When analysts refer to a R100 share as cheaper that a R10 share on TV, what they mean is that the P/E ratio is lower, not the price of the share. Price does not indicate value at all.

What is a P/E ratio?

It is the ratio between a share’s price and profit (earnings). It is calculated by dividing the price of the share by the latest annual earnings per share of that company. This is called the Price/Earnings ratio or P/E. The P/E of an index is the weighted average of the P/E ratios of all the shares that constitute the Index. It is important to note that P/E is not a percentage, but a ratio. The P/E is the exact inverse of the earnings yield (earnings divided by price) which is a percentage.

How does it work?

P/E is used more often than earnings yield as an evaluation tool because it moves in the same direction as price. Let me explain. Earnings are normally declared only twice a year by a company. With earnings stable for 6 months, the P/E will go up when the share price goes up and come down when the price comes down. For example: Share A is trading at R10 and the latest annual earnings per share (EPS) is R2. The P/E is therefore 5 times (10 / 2). If the price of A increases to R12, the P/E increases to 6 times (12 / 2). However, if the earnings increase (after 6 months), the P/E declines. Company A announces a 25% increase in EPS to R2.50. If the share price is still R12, the P/E will fall to 4.8 (12 / 2.5). An increase in earnings therefore means that the share became cheaper, lower P/E ratio. A decline in earnings will make the share more expensive as the P/E ratio will increase.

Using P/E to evaluate markets:

The P/E ratio can be used in two ways to evaluate a share or a market. The share or Index can be compared to its historic P/E ratio or different shares or Indices can be compared to each other on P/E ratios.

Relative to other World Markets:

Comparing the JSE with other world markets, all factors pertaining to our market must be taking into account.  For instance: economic growth, productivity, inflation, exchange rate, profit potential, political environment, etc. All these factors will influence investor sentiment and therefore the P/E ratio. Shares in a sector or an industry can also be compared in the same way as Indices of markets. In this list SA is trading at a P/E that is lower than most markets.

Historically:

Equity markets or Indices can also be evaluated relative to its own historical P/E and other world markets. By looking at historical levels, the index can be rated cheap or expensive.

JSE All Share Index P/E Ratio Nov 2012:

The JSE Index P/E was 14 times in Nov 2012. We can see there were big swings, from 26 times before the 1969 crash to only 4 times after the Rubicon speech in the 1980’s. The long term mean P/E is 12, which means that the JSE is currently a little bit more expensive than its mean average. It is however not overly expensive as it is still below the first standard deviation of 16.

Within the JSE Index there is however a big divergence. You can easily see that the Industrial shares (Index) are quite expensive on a P/E ratio of 18, but the JSE Resources Index is trading at a P/E of just above 10.

JSE Industrial Index P/E

JSE Resources Index P/E

Interpretation:

Does this mean that you must rush in and buy all the shares with low P/E ratios because they are cheap and avoid all high P/E shares? Definitely not. There are very good reasons why shares or markets are cheap. Most of that has to do with profit or earnings expectations.

Consensus earnings growth forecasts for the Resources Index is only 3 to 4%. For the Industrial Index the forecast is more than 20%. This goes a long way in explaining why there is such a big difference in P/E ratios. Investors are prepared to pay more (higher P/E) for shares with higher expected earnings growth than those with low growth. As explained earlier, if earnings decline the P/E ratio increase immediately in any case. Unfortunately earnings growth forecasts are only available to stockbroking firms. These expectations are regularly published in research reports available to Sanlam iTrade.

Gerhard Lampen.

Head – Sanlam iTrade.

1Comment
  • iTrade Fantasy League Announcement | iSayiTrade Blog
    Posted at 14:35h, 22 May

    […] a lot lower which meant the P/E ratio increased to very overbought levels, see graph (also see the article explaining P/E ratios).  At a P/E ratio of more than 17 it was already more than one standard deviation above the mean. […]

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