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Interpreting company reports and accounts

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5. Price earnings ratio (P/E)

Price Earnings Ratio (P/E) = Current market price of share / EPS

The idea of the P/E is that it tells you how many years you would have to wait to get your money back on your investment.

If, for example: Goodco's current share price is £1.08 and the EPS is 6p, its P/E is 18. (108 / 6 = 18). This means that if you buy a share, and its EPS stays at 6p, you will 'get your money back' over 18 years. Unfortunately:

• EPS rarely stays the same. (Nor do you want it to.)
• Companies don't actually pay out all their earnings as dividends, so you won't 'get back' 6p every year for 18 years

So P/E is a poor indicator of your 'payback' period. But it is a good indicator of the general confidence the market has in the company's ability to grow.

A company with a high P/E (>20) is one where the market anticipates rapid growth and is willing to pay a price for the shares beyond what is justified by historical earnings.

A company with a low P/E (<5) is one which is out of favour, or which is at the bottom of an industry cycle, and in which the market sees little excitement.

The critical question is how should you look at P/Es?

It is worth looking at the principles adopted by Ben Graham, the 'father' of value investing:

• Consider buying companies that are continually growing their sales, but also doubling their EPS every ten years
• Consider buying companies whose P/E is below that of competitors in the same industry
• Consider buying companies whose P/E is below its own past PE ratio (i.e. EPS rising, P/E declining)
• Consider avoiding companies with very low or very high P/Es
• Consider looking to buy stocks with a P/E of between 7 and 10

It can be tempting for investors to buy into low P/Es but if you do, try to find an explanation for the low rating before hand. There may be a genuine reason - e.g. a publishing company may be making good earnings now but has a low P/E because the market knows that its most valuable copyrights are due to expire. Research the company to make sure there is not some news that everyone else but you knows about.

As for high P/Es - the ratings of 40+ recently enjoyed by high technology and internet stocks - well, what can one say?
They make no profits, but have huge capitalisations, because the market expects growth. At this point, the normal rules of investing give way to a gambling spirit, and rational analysis is replaced by theological belief.

Further tips:

• Averaging over time
  To iron out short-term distortions, calculate ratios over a number of years. This will give you a truer picture of the company's performance.
• Trailing and leading P/Es
  The trailing P/E is based on last year's earnings. The leading P/E is based on estimated future earnings (and should be treated with caution).
• Ignore one-offs
  For example, a large and unforeseeable bad debt, or a natural disaster, or a large one-off profit from the sale of a piece of land. They don't give a true picture of the company's ongoing performance.
• P/Es are no use for companies with erratic earnings
  - like insurance companies or commodity traders - or other specialist companies like investment trusts or property companies where investors are mainly concerned with the value of the assets.
• Watch out for creative accounting,
  especially companies fudging their earnings figures. A reliable measure of real earnings is dividends + the increase in net assets per share.

1. The five main components of a set of report and accounts 2. What to look for in the directors' report 3. What to look for in the P&L 4. Earnings per share (EPS) 5. Price earnings ratio (P/E) 6. What to look for in the balance sheet 7. What to look for in the cash flow statement 8. What to look for in the auditors' report 9. Other information sources 10. Conclusion

Recommend Reading

• Accounting for Growth