The humble Price-to-Earnings (P/E) Ratio is perhaps the most widely understood metric in the investment world. But you shouldn't use it as a proxy for a trading decision. This is because the number on its own, has very little actionable insight.
You see, the P/E Ratio is a lagging indicator. The numerator (Price) is the end product of a jostle between millions of buyers and sellers in the market. It is also the best gauge of all known and expected information out there. The denominator (Earnings) is the trailing 12 months' earnings per share of the company. And we know the disclaimer that historical result is not representative of future performance.
Usually, the broker analysts provide what is known as the forward P/E Ratio, which is to take the same stock price, and divide it by their own forecast of next 12 months' earnings per share of the company.
Now, there is a lot of uncertainty baked into the analyst's estimate, and it will be a matter of which analyst do you trust the most.
So what value does the P/E Ratio have?
You can use the P/E Ratio as a yardstick to find out what other investors (a.k.a. the market) think about the stock (and the company as a whole).
If other investors are paying 25 times per dollar of earnings for this company (P/E = 25), are you willing to be the bigger fool and pay 26 times per dollar of earnings for this company?
If the answer is yes, congratulations! You can go ahead and submit the buy order. Otherwise, you need to do some more digging.
To properly evaluate the P/E Ratio, you need to research it across two dimensions: (a) against time; and (b) against peers.
(a) Against time
It is not difficult to find websites providing historical P/E data of a company. You can pull up the numbers and check where the current P/E Ratio stands relative to the highest and lowest value over history.
For example, Table 1 below gives the P/E Ratio of CapitaLand as of 10 June 2020, and its highest and lowest values over the past ten years.
CapitaLand is currently priced somewhere near the bottom end of the range. At this moment, the market is not paying top dollar for the company's earnings, which is understandable given the COVID-19 situation.
But if the P/E Ratio is near its lifetime high, take it as an omen that the market is very hopeful - wildly optimistic perhaps - about the company. Too much euphoria flashes a warning sign, because you are going to find few buyers to push up the stock price further, even when you are confident the company will perform better down the road. When demand levels off and more sellers come onboard, there is only one direction for the price to go.
Some broker analysts go one step further and derive the mean value and standard deviation of the P/E Ratio, and tell you the stock is currently trading N standard deviations below the mean.
That's applying additional statistical analysis, but it doesn't necessarily mean the stock is a buy. There must be a reason for the metric to be so far below the mean. You may want to check out recent developments and see what could be causing this deviation.
Take note that P/E Ratio is meaningless if the company has recorded a loss. It is Price-to-Earnings Ratio after all.
(b) Against peers
Another way to use the data is to compare the P/E Ratio against other competitors in the same industry. For example, Table 2 below shows the current P/E Ratio of local real estate developers listed on the Singapore Exchange as of 10 June 2020:
Ho Bee Land has the lowest P/E Ratio on the list while City Developments Limited ("CDL") has the highest. So the market is valuing Ho Bee Land cheaper than CDL at the moment.
If you think the market - and everyone else - is wrong, that Ho Bee Land should be worth more, then congratulations again, you have found yourself another trading opportunity...
Except I wouldn't be so quick to hit the 'Buy' button just yet.
Because there can be idiosyncratic biases that cause the market to price a company more or less favourably compared to other companies in the same sector. For example, Graph 1 below plots the difference in P/E Ratio between CapitaLand and CDL over the past five years.
As seen from the graph, the market has been pricing CapitaLand at a P/E discount relative to CDL since Q1 2017. What you want to know is whether the P/E discount (premium) is expanded (compressed) now compared to other times in history. There may be a company-specific reason for this phenomenon, and it is up to the inquisitive investor to find out.
Hopefully at this juncture, I have given you sufficient ideas on how to slice and dice the P/E Ratio effectively, so as to arrive at meaningful insights on your choice stocks.
Earnings are lumpy and do not change from day to day. Hence the stock price is the bigger influencer on the P/E Ratio.
Talking about price, I would like to bring up Benjamin Graham's renowned parable of "Mr. Market", as retold by Warren Buffett in his 1987 Berkshire Hathaway Letter to Shareholders [link]:
In other words, despite all the advice about staying invested in the market, you don't have to buy NOW if the price is unfavourable (or the P/E Ratio is too high for your comfort.)
Market goes in cycles, and there will be a new price everyday. A window of opportunity will present itself if you wait patiently. Just remember to squeeze the trigger when the time comes.
You see, the P/E Ratio is a lagging indicator. The numerator (Price) is the end product of a jostle between millions of buyers and sellers in the market. It is also the best gauge of all known and expected information out there. The denominator (Earnings) is the trailing 12 months' earnings per share of the company. And we know the disclaimer that historical result is not representative of future performance.
Usually, the broker analysts provide what is known as the forward P/E Ratio, which is to take the same stock price, and divide it by their own forecast of next 12 months' earnings per share of the company.
Now, there is a lot of uncertainty baked into the analyst's estimate, and it will be a matter of which analyst do you trust the most.
So what value does the P/E Ratio have?
You can use the P/E Ratio as a yardstick to find out what other investors (a.k.a. the market) think about the stock (and the company as a whole).
If other investors are paying 25 times per dollar of earnings for this company (P/E = 25), are you willing to be the bigger fool and pay 26 times per dollar of earnings for this company?
If the answer is yes, congratulations! You can go ahead and submit the buy order. Otherwise, you need to do some more digging.
To properly evaluate the P/E Ratio, you need to research it across two dimensions: (a) against time; and (b) against peers.
(a) Against time
It is not difficult to find websites providing historical P/E data of a company. You can pull up the numbers and check where the current P/E Ratio stands relative to the highest and lowest value over history.
For example, Table 1 below gives the P/E Ratio of CapitaLand as of 10 June 2020, and its highest and lowest values over the past ten years.
| Date | P/E Ratio |
|---|---|
| 10 Jun 2020 | 7.22 |
| 30 Jan 2013 (Highest) | 18.57 |
| 06 Apr 2020 (Lowest) | 6.26 |
Table 1, Source: Morningstar
CapitaLand is currently priced somewhere near the bottom end of the range. At this moment, the market is not paying top dollar for the company's earnings, which is understandable given the COVID-19 situation.
But if the P/E Ratio is near its lifetime high, take it as an omen that the market is very hopeful - wildly optimistic perhaps - about the company. Too much euphoria flashes a warning sign, because you are going to find few buyers to push up the stock price further, even when you are confident the company will perform better down the road. When demand levels off and more sellers come onboard, there is only one direction for the price to go.
Some broker analysts go one step further and derive the mean value and standard deviation of the P/E Ratio, and tell you the stock is currently trading N standard deviations below the mean.
That's applying additional statistical analysis, but it doesn't necessarily mean the stock is a buy. There must be a reason for the metric to be so far below the mean. You may want to check out recent developments and see what could be causing this deviation.
Take note that P/E Ratio is meaningless if the company has recorded a loss. It is Price-to-Earnings Ratio after all.
(b) Against peers
Another way to use the data is to compare the P/E Ratio against other competitors in the same industry. For example, Table 2 below shows the current P/E Ratio of local real estate developers listed on the Singapore Exchange as of 10 June 2020:
| Security | P/E Ratio |
|---|---|
| City Developments | 15.34 |
| Hiap Hoe | 13.83 |
| Bukit Sembawang | 13.18 |
| UOL | 13.00 |
| Frasers Property | 9.43 |
| Oxley | 8.81 |
| Heeton | 8.33 |
| CapitaLand | 7.22 |
| GuocoLand | 6.24 |
| UIC | 5.57 |
| OUE | 4.53 |
| Ho Bee Land | 4.20 |
Table 2, Source: Morningstar
Ho Bee Land has the lowest P/E Ratio on the list while City Developments Limited ("CDL") has the highest. So the market is valuing Ho Bee Land cheaper than CDL at the moment.
If you think the market - and everyone else - is wrong, that Ho Bee Land should be worth more, then congratulations again, you have found yourself another trading opportunity...
Except I wouldn't be so quick to hit the 'Buy' button just yet.
Because there can be idiosyncratic biases that cause the market to price a company more or less favourably compared to other companies in the same sector. For example, Graph 1 below plots the difference in P/E Ratio between CapitaLand and CDL over the past five years.
 |
| Graph 1, Source: Morningstar |
As seen from the graph, the market has been pricing CapitaLand at a P/E discount relative to CDL since Q1 2017. What you want to know is whether the P/E discount (premium) is expanded (compressed) now compared to other times in history. There may be a company-specific reason for this phenomenon, and it is up to the inquisitive investor to find out.
Hopefully at this juncture, I have given you sufficient ideas on how to slice and dice the P/E Ratio effectively, so as to arrive at meaningful insights on your choice stocks.
Earnings are lumpy and do not change from day to day. Hence the stock price is the bigger influencer on the P/E Ratio.
Talking about price, I would like to bring up Benjamin Graham's renowned parable of "Mr. Market", as retold by Warren Buffett in his 1987 Berkshire Hathaway Letter to Shareholders [link]:
Ben Graham, my friend and teacher, long ago described the mental attitude toward market fluctuations that I believe to be most conducive to investment success. He said that you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market who is your partner in a private business. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.
Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market's quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload your interest on him.
Mr. Market has another endearing characteristic: He doesn't mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manic-depressive his behavior, the better for you.
But, like Cinderella at the ball, you must heed one warning or everything will turn into pumpkins and mice: Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful. If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence. Indeed, if you aren't certain that you understand and can value your business far better than Mr. Market, you don't belong in the game. As they say in poker, "If you've been in the game 30 minutes and you don't know who the patsy is, you're the patsy."
In other words, despite all the advice about staying invested in the market, you don't have to buy NOW if the price is unfavourable (or the P/E Ratio is too high for your comfort.)
Market goes in cycles, and there will be a new price everyday. A window of opportunity will present itself if you wait patiently. Just remember to squeeze the trigger when the time comes.
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