The ratio tells you that you pay this much for a stock that earns this much. So for a PE ratio of 16, it tells us that market participants are willing to pay 16 times the expected earning of the share.
News came out from Inquirer and PhilStar last week on why PSE stumbled that same week before recovering towards the end of the week. How about that, two different broadsheets interviewing two different market analysts, saying the same thing? Anyway…
Stocks went lower Monday last week for the fourth session, in this year where we have seen a number of “all time highs”. Decline was attributed to profit-taking on certain stocks with recent surge in prices (which is normal after a series of runs), as well as US and EU fiscal concerns. Another major insight was that foreign investments may be moving their money towards cheaper investments, to China and North Asia where P/E ratio was lower at about 10 whereas in PSE, we are at about 16. It further explained that:
“A P/E ratio of 16 means investors are paying 16 times the amount of money that the Philippine market is expected to make in 2013. So we might see more profit-taking from foreign funds,” Inquirer
“The market continued to correct. We had some issues on valuation with the market being so pricey in comparison to historical standards. We are also one of the most expensive in the region, that’s a concern for some investors so they decided to lighten up,” PhilStar
Just wanted to add a few more nuggets on P/E ratio.
Stock Price / (Company Earnings per Outstanding Share).
Simply put, the ratio tells you that you pay this much for a stock that earns this much. So for a PE ratio of 16, it tells us that market participants are willing to pay 16 times the expected earning of the share. Why so? Likely because it expects higher earnings in the coming years. Rosy prospects which will increase earnings eventually. A high PE ratio may not necessarily be good though, especially if it’s way above the market levels.
Peter Lynch also offers another perspective. If we assume a company earns a constant amount, and assume a constant number of shares, then the PE ratio tells us how many years it will take for us recover our initial investment. If you pay P90 per share for a company that earned P100M this year (and there are 10M shares in the market), then PE ratio is = 90 / (100M/10M) = 9. At this constant rate of earnings annually, it will take 9 years to recover the initial P90 investment. Of course, not all things are constant, (earnings may go up or down, etc) but still this gives us how much the market values the company based on present and expected future earnings.
Having said that, this also shows that the market is forward looking, that current market price already incorporates future earnings and foreseen developments (up to 9 years in the example, if you wish). As such, any minor developments now may no longer affect the price of the share. On the other hand, any major developments not factored in or not anticipated (new projects, acquisitions, mergers, government policies, economic downturns, calamities and accident, rumors etc) may suddenly change the market valuation (price) and potential income (earnings per share), hence the P/E ratio.
Not an Exact Science
In stocks, there is really no exact science as such the P/E ratio should be used as a fundamental tool rather than as stand alone number. Further, it is best used comparatively among stocks in the same sector (which ones look undervalued or overvalued among competitors or within the industry) as this removes the bias in terms of company size. Which ones are undervalued or overvalued relative to its earnings. And as is in the articles, investors also use this to compare markets, such as Philippine market vs China and North Asia.