question about P/E

dllive

Im looking to invest in individual shares. This is new territory for me. Ive been reading up on what P/E's are. My head's spinning a bit: if a P/E is 8 - that means for every £8 I spend, I get £1 back - or it takes 8 years for me to get my money back. Thats bad isnt it? And yet when a company is doing well and is expected to grow - their P/E goes up, so this means it takes even longer to get my money back. I think Im missing something fundamental here. Could someone explain in the most layish of laymans language for me?

Geoffo_M

Neither of those - it's a ratio of the current price of its share to its earnings per share. If a company has issued 100,000 shares and is its earnings are £50,000 per annum, then it is earning 50p per share. If it's current share price is 400p, then it's P/E is 8 (400/50). The lower the P/E, the better. It's simply one of the ratios of judging the value of a share price

Baz_2

You are right about the amount of time to repay your investment analogy.

The higher the PE ratio the more confidence the market has in the company.

The lower the PE ratio the less confidence the market has in the company.

Think of it this way. If you had too companies, one doing really well, making profits, low debts, high value assets and another with high debts, struggling to make profits and its assets may not be worth as much as they state which one would you leave you money in the longest?

The former obviously. If you have a low PE ratio, then in reality people are less inclined to leave there money in the company, i.e in and out in as little time as possible, hence the low ratio. They want there investment repaid as quick a s possible. And to get returns as high as that and as quick as that means higher risk. If the ratio is higher it means that investors are more incline to leave there investment in the company and a re prepared for there investment to be returned to them slower, i.e lower risk.

Obviously too high a PE ratio could mean that the risk is that low that any returns would be minimal.

Also the type of sector the company is in will also dictate risk levels and the PE ratio.

Look for a PE of between 12 -20 for a nice balance between risk and returns.

StevieJ

Another complication is the earnings element (E) may be based on previous earnings or future forecasts, so basically a P/E based on previous earnings is unlikely to reflect the true position when entering a recession. Also low p/e ratios tend to be low for a reason so you need to understand that reason.

Kif_inti

Personally I would give little merit to a P/E ratio found in the financial columns as this is always past performance

A prudent investor will, amongst other things, always look at a companies recent news announcements to the stock-market re trading updates profit warnings etc

Looking at your question;
If a company earns at an 8 to 1 ratio it's quite possibly that it may pay only part of the profit in dividends

For instance if a dividend is twice covered it means they pay out half of the profit to shareholders and re-invest the remainder
Good luck

dllive

Interesting.... but why would anyone pay money only to wait 8 years (if the P/E is 8) to get it back? Surely it doesnt mean I pay £5 in and then wait 8 years to make my money back?

StevieJ

dllive wrote: »

Interesting.... but why would anyone pay money only to wait 8 years (if the P/E is 8) to get it back? Surely it doesnt mean I pay £5 in and then wait 8 years to make my money back?

Somehow I don't think you have quite grasped the concept.

http://en.wikipedia.org/wiki/PE_ratio
or
http://www.investopedia.com/terms/p/price-earningsratio.asp

Perhaps you should look at it in terms of return e.g. if you put your money in the bank you may receive only 0.5% at the
moment. If you invest in a company with a p/e of 5 and all is paid out in dividends you will receive 20% although your initial outlay willbe at risk. In practise all the earnings will not be paid out in dividends as thet may require the funds for other things e.g. capital
expenditure, if we assume that half the proifits are paid out in divis your return would be 10%. You can still sell your shares although you may not receive what you paid for it (this may be more or less). If a company is expected to grow fast you expect a
higher p/e (and lower divis) as profits in the future are expected to be higher, if no growth e.g. Water companies you would expect a lower p/e and a higher current return (higher divis). If a company is expected to struggle or go bankrupt you would
also expect a lower p/e.
Hope this helps?

princeofpounds

Interesting.... but why would anyone pay money only to wait 8 years (if the P/E is 8) to get it back? Surely it doesnt mean I pay £5 in and then wait 8 years to make my money back?

Hi dllive, I'm an equity analyst, so looking at this sort of thing is my profession. The advice you have been given above is, in simple terms, basically right, but there is much more to it than that.

But first, let me answer you question here. Why would anyone wait 8 years to get their money back? Well the truth is they are not - you are forgetting something.

At the end of the 8 years they could sell the share (which they still own!) and get the money back. So they will have received the original money back plus the same amount all over again. This would correspond *crudely* to a 12.5% return on the equity per year, which is pretty good putting aside questions of risk. Of course, in reality the company may not make the earnings people expect, it may waste them in unprofitable investment, and the valuation of the stock can change so you can't sell it back for the money you paid. Or maybe it can all turn out better than expected!

princeofpounds

Now for some more general stuff. I have to rush but I'll contribute more later.

Geoffo's definition of P/E is the correct one. He is also almost right to say that lower P/Es are best - studies have shown there is a small but persistent effect that lower-rated shares outperform in aggregate. But this is not the case universally.

As a quick example of how real life can be more complicated, some cyclical stocks (like steel companies) make so little money when conditions are so bad that the P/Es are sometimes really high at the worst point and low when the company is raking it in as investors do not believe either situation will persist for ever.

But P/E itself is actually a mathematical simplification of another model! I'll get into this later.

Jake'sGran

You might be interested in this article by the reverred Antony Bolton of Fidelity. (I am not very good at links!)




From The Sunday Times

April 12, 2009


Ten tips from one of City's top fund managers

Stockpicker reveals the ten lessons he has learnt from more than three decades of investing, as his new book is published

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StevieJ

Do you mean this ?

http://www.timesonline.co.uk/tol/money/investment/article6077550.ece