5 Steps to Using P/E Ratio Effectively

P/E Ratio is an indispensable stock indicator to value a company’s share. It is to compare a company’s share price with its earnings. How much would you pay to buy a company that makes RM 1 Million a year? If your answer is RM 5 Million, then, P/E Ratio is 5 as it is 5 times more than its annual earnings.

Usually, P/E Ratio is higher for public listed companies. This is because they are liquid and deemed to be less risky than most privately-owned enterprises.

However, P/E Ratio is not useful to all types of companies. Here, I would share how I use P/E Ratio effectively to value a company’s share.

Step 1 – Profits
P/E Ratio works most effectively for companies that achieve consistent growth in profitability. Instead of looking at a company’s P (Price), I would start by looking at its E (Earnings). This is because, in general, ‘E’ drives the ‘P’. High E usually drives higher P. After all, what kind of P would you pay for a company without E? I believe you get the point. Hence, Step No.1 is to find companies that grow their ‘E’s consistently in both good and bad economic situation.

Step 2 – Range
Next, I would build a multi-year range of P/E Ratios. I would use PETRONAS Dagangan Bhd (PDB) for case study. From 2006 to 2014, PDB recorded its lowest P/E Ratio at 7.98 in 2006 and its highest P/E Ratio at 38.38 in 2013.

P/E Ratio Range = 7.98 – 38.38

Step 3 – Average
Step No.3 is to calculate the average P/E Ratio of PDB. In that 10-year period, PDB’s P/E Ratio averages at 19.43.

P/E Ratio Average = 19.43

Step 4 – Latest
Once you have the average P/E Ratio, the next step is to compare PDB’s P/E Ratio average with its latest P/E Ratio. For instance, PDB’s P/E Ratio in 2014 was 33.90. It is higher than Average P/E Ratio of 19.43. What does it mean?

If the latest P/E Ratio is higher than its average, then, shares would be deemed as overvalued. Existing owners may consider selling their shares to reap their investment rewards. PDB has P/E Ratio of 33.90. It means, for every RM 1 Million in earnings, the price to invest was RM 33.9 Million. Most investors are able to find a company that makes RM 1 Million at a much attractive prices.

If the latest P/E Ratio is lower than its average, then, shares would be deemed as undervalued. New investors may be attractive to buy shares of strong companies at cheaper prices.

Step 5 – Trend
The final step is to examine the trend of a company’s P/E Ratio over the last 3 – 5 years closely. The trend would indicate whether the company’s shares are becoming cheaper or becoming more expensive. This is the P/E Ratio of PDB for the past 5 years.

If P/E Ratio is growing, then, shares are becoming more expensive. In this case, the growth in PDB’s share price had outpaced its growth in shareholders’ earnings. This is particularly true from financial year ended March 2011 to financial year 2013. During the period, share price grew 90.1% while shareholders’ earnings remained around RM 800 – 900 Million per annum.

If P/E Ratio is declining, then, shares are becoming cheaper. Once again, this is only true for companies that grow earnings consistently. A drop in P/E Ratio means that the growth in share price is slower than the growth in earnings. If P/E Ratio maintains, it means the growth in share price is in line with the growth in earnings.

This article is written by Ian Tai Creator of Bursaking, the Simplest Instant Stock Filter in Malaysia.