Have you ever wondered how professional investors pick their stocks? For most people, investing in the stock market is a scary and daunting venture. We have all heard stories before about people who lost all their savings by making stock investments that seemed like great opportunities at first but later turned out to be costing money instead.
There is so much that can go wrong when you start investing. Even if you are absolutely sure that your selection of stocks has no bad apples in it, who is to say you will actually make a profit? Good investments are a combination of:
- strong fundamental analysis
accurate timing
correct selection of investment vehicles
proper hedging
Fundamental analysis is probably the most important but also the most time consuming part of your research. Over the course of this series, we will make you familiar with the basics of fundamental analysis, starting with an introduction of one of the most widely used ratios in company valuation, the P/E ratio.
What is the P/E Ratio?
The P/E ratio is a ratio that gives you an indication whether the current price of the stock is in proportion to the earnings the company has generated in the last year.
Sounds complicated? Let’s take it back a couple of steps:
When you invest in a stock, you want to see a return on your original investment. This can happen through various ways, but the two most common reasons you will realize return on your original stock investments, is either through an appreciation in the stock price (capital gains) or through the payment of dividends (dividend yield) by the company. You want to make sure that your money can benefit from as much capital gains and dividend yield as possible.
The P/E ratio tries to capture how much investors are willing to pay for every RM 1 of earnings. Let’s say that a company has a P/E ratio of 20. That means that the price of the stock is 20 times higher than the earnings per share. Or, in other words, investors were willing to pay RM 20 for RM 1 of earnings. In itself that won’t say much but if you benchmark that against past results or industry competitors you can get a clear picture of how investors value the company.
As investor you always want to look for the lowest P/E ratio because that would mean the highest earnings compared to how low the stock price is. If the P/E ratio of a company is higher than the average P/E of industry competitors, the stock could be overvalued. If the P/E ratio is lower, the stock could be undervalued. Investors typically invest in stocks that they expect to go up in the future. If you buy a stock with a low P/E, your returns will be proportional to that P/E ratio, regardless of what happens to the stock price. If the stock appreciates, the P/E ratio will go up, but that won’t affect your returns since you bought in at a lower P/E.
That is why undervalued stocks are so attractive. Next to having higher than usual dividend yields, they are also more likely to appreciate in the future.
The P/E ratio can be used as a quick assessment of how much return you can expect in the short term, and it can also indicated a direction for the stock price.
How to use P/E as an indicator of short term returns
If a company has a P/E ratio of 20, you would have to invest RM 20 to make the company earn RM 1. If the company has a dividend payout ratio of 0.5, it will pay 50% of that RM 1 back to investors. That means that for every RM 20 invested, you stand to make RM 0.50. Which translates to a return of 2.5%, excluding any tax and transfer fees.
How to use P/E as an indicator of short term stock price movement.
If the P/E ratio is relatively low, the stock could be undervalued and could therefore appreciate in the future. On the other hand, if the P/E ratio is high, the stock could be overvalued and could see a drop in the near future.
However, a high P/E ratio could also indicate that investors expect to see significant growth in earnings in the future, for example with growth stocks. In this case the stock price has already appreciated in anticipation of higher earnings. That being said, a low P/E does not always mean a good buy and a high P/E does not always mean a bad buy. For example, a low P/E could also indicate that the stock price has dropped severely compared to earnings. In this case, you should ask yourself what is driving the stock price down.
If it is just market sentiment, then the stock will likely pick up in the future, but if the cause is structural then the company might actually go bankrupt. Similarly, a high P/E does not necessarily have to be bad. If the company is planning a move overseas to a market where their P/E ratio is not that high, the stock might actually be a good investment. All of this is of course not set in stone, and you should not use the P/E ratio as your exclusive indicator of stock price movement.
How is the P/E ratio calculated?
The P/E ratio is a division between two numbers, the P, which is the current price of the stock and the E, which represents the earnings per share of the company.
The current price of the stock
The price of the stock is determined by supply and demand in the stock market. If investors think the stock is overpriced they will buy less and if it is under-priced, they will buy more. This effect causes the stock price to always be a representation of how investors value the company.
The earnings per share (EPS)
The earnings per share are calculated by dividing the annual after-tax earnings of the company by the amount of common stock outstanding. Usually this number is given in the annual and quarterly reports that company issue. EPS is indicative of how much earnings the company generated compared to how many shareholders the company has. EPS is one of the most important earnings ratios and is very important in determining your dividend yield.
How to Use the P/E ratio
Let’s see how we can use the P/E ratio to analyze the 30 companies listed on the FTSE Bursa Malaysia KLCI. This list is comprised of the 30 companies listed on the Bursa Malaysia that have the most market capitalization. Market capitalization is the multiplication of the stock price times the number of shares outstanding, and indicates the size of the company. For further elaboration of this topic please read the article here.
Stock 101 Quiz
