The current market consensus suggests that our market is trading at elevated levels with little short-term upside movement expected.

This can be seen by the JSE All Share Index trading at a P/E multiple of 21.57 relative to the __historical average around 15__.

But when digging a bit deeper its the large cap companies (by market cap) in our Index that trade at higher than average P/E ratios:

The more local household names, trade at lower than average P/E ratio’s:

You often hear analysts comment that “the market is trading at an expensive PE ratio”. What does this actually mean?

Stocks with low price to earnings (P/E) ratios always attract investors, more so given the high equity valuations which do not reflect the current global economic climate.

Many stock pickers believe that companies with low P/E ratios are currently the safe bets, especially if they have good performance and dividend paying record.

The big question is should an investor buy into the ‘P/E story’?

**What exactly is a P/E Ratio?**

The price-to-earnings ratio (P/E) is probably the most widely used – and thus misused – investing metric, the reason being it is easy to calculate it.

**Definition**: A P/E also known as “price multiple” can be defined as the current market price of a company share divided by the earnings per share of the company.

It’s a valuation metric that indicates the expected earnings of a company.

In general, a high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E.

The formula is as follows:

Price-to-earnings ratio = Price per share / Earnings per share.

**The common use of P/E ratios**

Price earnings ratio is perhaps the most widely used metric in the financial community, and for that reason alone, it can be a meaningful starting point in determining the relative worth of a company.

The P/E ratio can be calculated in two different ways.

First, an investor can look at a stock’s price relative to its trailing earnings, in which case the denominator would be the last four quarters of a company’s earnings.

For example, if a stock is trading at R40.00 per share, and it earned R1.00 over the last year, it is trading at 40 times (40x) its trailing earnings.

In other words, an investor is willing to pay R40.00 for every R1.00 of actual or historical earnings that the company has generated.

The second P/E method is forward looking, and calculates the price relative to the next four quarters of predicted earnings.

Using the same values, an investor is willing to pay R40.00 today for the promise of R1.00 of earnings in a year’s time (perhaps because the investor is convinced that the company will be able to perpetually grow earnings).

**Sectors where P/E ratios are most relevant**

The P/E ratio is most appropriate in the valuation of companies that have relatively stable earnings.

Such companies can be found in sectors where prices and demand are relatively stable, such as Regulated utilities or consumer staples, or industries with highly variable costs.

Variable cost industries allow a company to adjust expenses as sales fluctuate, keeping profit margins and earnings relatively steady.

**The different types of PE ratios**

__Trailing P/E ratio__

The trailing P/E ratio is the sum of a company’s price-to-earnings, calculated by taking the current stock price and dividing it by the trailing earnings per share for the past 12 months.

The formula is:

Trailing P/E ratio = Current Share Price / Trailing Twelve Months Earnings per share

How to read the Trailing P/E ratio:

The trailing P/E ratio is considered to be more reliable as it’s based on actual earnings therefore is the most accurate.

However stock prices are constantly moving while earnings remain fixed. As a result it is sometimes better to use a forward P/E to predicting the earnings outlook.

A company with a high trailing P/E is commonly referred to as a growth stock.

__Forward P/E__

A Forward P/E is a measure of the price-to-earnings ratio (P/E) using forecasted earnings for the P/E calculation.

While the earnings used are just an estimate and are not as reliable as current earnings data, there is still benefit in estimated P/E analysis.

The forecasted earnings used in the formula can either be for the next 12 months or for the next full-year fiscal period.

The formula is:

Forward P/E = Market Price Per Share / Expected Earnings Per Share

__How to read the Forward P/E:__

The forward P/E of a company is often used to compare current earnings to estimated future earnings, thus if earnings are expected to grow in the future the forward P/E will be lower than the current P/E which is good for investors.

Whilst if the forward P/E is higher than current P/E then earnings are expected to be lower, which is not a good sign for investors.

**Busting the hype around high or low P/E ratio**

A high P/E may be warranted due to several reasons.

Quality of management – This refers to management with experience and a proven track record of steering a company to profitability even in tough economic climates.

This includes growth of company, high expected profits, high return of equity / high return on capital, innovation that can increase productivity, reducing cost and increasing bottom line earnings and many more.

What about Low P/E stocks?

There is a general conception that stocks that trade at low PE ratios relative to their peer group must be mispriced and thus attractive.

I don’t believe in this notion of low P/E stocks are attractive buys, as cheap stocks can be discounted for good reasons such as poor growth prospects, and negative prospects in the industry such as regulation & increased competition that drives down the profit margins and many more.

A P/E ratio can be artificially lifted by transitionary earnings (earnings that cannot be sustained) one should pay less per ZAR of earnings and the P/E ratio should be low.

On the other hand if earnings are temporarily depressed, causing the P/E ratio to be low, but can grow and be sustainable in the future, this makes the stock attractive.

Essentially if investors expect a company to deliver weak earnings in the future, its share price will fall and the P/E ratio re-rates downwards.

Therefore a low P/E stock should only be attractive if an investor has a high degree of certainty that future earnings can grow and be sustainable.

**Limitations of the P/E ratio**

P/E ratio can be a very misleading ratio as most people feel that a lesser P/E is cheap and higher P/E is expensive, and this is a highly incorrect notion.

Only using a P/E ratio to decide about buying a particular stock is like buying a car being offered on discount without paying heed to brand, mileage, safety features, maintenance costs, parts availability etc.

In essence the P/E parameter is not a silver bullet tool when investing.

It’s one of the parameters from the fundamental analysis school, which is much larger than this one attribute.

Take Brait for example: BAT is one of our favorite holding companies, and a member of Rob’s latest share “football team“.

Now BAT current P/E ratio is currently 2.15, which is very low if you only take P/E ratios into consideration when making investment decisions. The fact of the matter is BAT is a holding company and is valued on Net Asset Value (NAV) rather than earnings (P/E).

So, investors who are investing based on P/E ratio are under a false sense of security that their investment will perform better.

Take the case of commodity companies.

Commodity prices are cyclical in nature. Prices go up or down based on a host of global factors, so does the profitability of companies dealing in those commodities.

As profits fluctuate lower valuations are given and a stock `s P/E will reflect that.

Investors should view the P/E ratio as an earnings expectation indicator and should therefore investigate what factors the market’s basing those expectations on.

To understand the broad factors that contributes to high or low P/E, get in touch with us and I can help you identify the financial variables that influence market valuations.

Here’s to profitable trading,

Michael Porter

Private Client Trader | Vunani Private Clients

michael@vunaniprivateclients.co.za

### Michael Porter

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