Price to earnings (PE) ratios are one of the most common valuation techniques for equities. Seasoned investors can judge if a share looks cheap or expensive by looking at the PE figure. Yet less-experienced individuals could benefit from having a better understanding of what the PE represents, its role in stock picking and in what situations it shouldn’t or couldn’t be used. To help you become a better investor, we explore the principles of PE valuation in five easy steps.

Along the way we also flag a number of picks for each of the retail, support services, technology and engineering sectors. In the former we highlight international apparel retailer SuperGroup (SGP), whose thriving websites are helping it to sate global demand and turnaround play Thorntons (THT). Our favoured support services names are recruitment play Hays (HAS) and online gambling-to-retail transaction processor Optimal Payments (OPAY:AIM), while in the technology space we gravitate towards insurance claims outsourcing software supplier Quindell (QPP:AIM) and multi-utility Telecom Plus (TEP). In engineering we like steam control equipment specialist Spirax-Sarco (SPX) and tobacco machine manufacturer Molins (MLIN:AIM).

1. What does PE mean?

You may have heard people say ‘that stock is on a PE of 10, it is a bargain’ or ‘the PE is 20, that’s far too expensive’. Although this may sound incomprehensible, it is quite easy to get to grips with PE ratios. They are essentially a representation of reward and risk. While the PE multiple is not a perfect valuation technique, it is an extremely useful starting point to evaluate valuation.

The PE number is obtained by dividing the latest share price by the earnings per share (EPS) figure. A high PE generally implies the market is confident with the company’s growth profile and/or the sustainability of its earnings. A low PE means the market has little faith in the firm, perhaps because of trading problems or a weak balance sheet. You can also get low PE ratios when a company has experienced a sudden drop in its share price, such as the result of a profit warning, and analysts haven’t yet adjusted their earnings forecasts.

It may also be that a company is recovering from a previous hit to earnings. Cyclical companies may be at the bottom of their ‘cycle’ so an investment may still be warranted if earnings are about to rebound. If you think about it, a cyclical company may trade at 100p and have 5p forecast EPS, equating to a PE of 20. Yet if earnings rebound to 10p the following year, the forward PE will be 10 - which is much more appealing territory.

It is important to use forecast EPS and not the historic number, as the stockmarket is forward looking. Future events are frequently discounted into the share price before they’ve happened, hence the phrase ‘it is often better to travel than arrive’ and why shares have a tendency to fall upon results announcements as this is the point when investors take profits, having previously bought shares in anticipation of a company achieving something specific.

Nearly all financial data websites have EPS and PE information freely available. You’ll need to ensure the PE data isn’t based on historical data, as that’s the norm for most data providers. Some of the more sophisticated financial data providers have average sector PE ratios which can be a very useful comparison tool against individual stocks.

2. Putting PE into practice

Let’s take electronics-to-washing machines seller Dixons Retail (DXNS) as the working example. Its share price is 48.4p and it is forecast by analysts to make 2.98p EPS in its financial year ending 30 April 2014. Divide 48.4p by 2.98p and you get a PE ratio of 16.2. Analysts tend to use pre-exceptional pre-amortisation numbers.

The PE figure tells you the number of years that the investment takes to pay for itself. Assuming Dixons’ share price and EPS figure remain constant, then it will take 16.2 years worth of 2.98p EPS to hit the 48.4p price an investor paid for a single share.

You can then use this PE figure as a comparison to the quoted peer group. For example, electronics play Darty (DRTY) has a PE of 31.7. This is elevated because the firm’s earnings have been depressed due to trading problems over the past few years including the demise of UK chain Comet. Argos-owner Home Retail (HOME) is on a PE of 19.4, which is higher than Dixons’ multiple because the Argos turnaround is going well and investors are clearly speculating that its other big brand, DIY outlet Homebase, will benefit from the housing market recovery.

Unfortunately there isn’t a single figure that represents fair value as every sector is different. As a very crude measure, you could say a PE in the range of 12 to 15 is correct for a stable, low-risk business - yet a fast-growing one with a competitive edge and significant end-market demand may also look reasonable value with a 18 to 20 PE ratio given potential earnings uplift. High-quality operators with strong brands, a robust balance sheet and solid end-market demand could easily command a PE of 20 to 25. Premium companies demand premium valuations.

3. High PE ratios - the good and the bad

A good example of a company with a high PE and deserved premium rating is Whitbread (WTB). Its Costa Coffee and Premier Inn hotel chains have large market shares and the firm still has significant growth opportunities warranting a multiple north of 20. Expansion is being self-financed. Investors are happy to buy the shares, despite the high rating, as earnings forecasts keep being nudged up and the share price has risen more than five-fold in the past half a decade.

Grocery delivery group Ocado (OCDO) trades on an eye-watering 171 times forecast earnings. That’s because the company is only expected to make a small profit in the near-term, but the market is happy to keep buying the shares for the longer-term opportunity. We are very surprised people still want to keep buying, given so much future growth already seems discounted into the share price. Why would you want to own a company valued at £3.6 billion that is loss making?

What’s even more astonishing is that Ocado hasn’t lived up to market expectations. The graphic (see below) illustrates how earnings forecasts set at the time of its IPO in July 2010 have proved to be widely off the mark. Earnings per share were meant to have hit 8.7p in the year ending November 2013, according to Goldman Sachs’ IPO forecasts. Yet the company reported a 2.16p loss per share. While Ocado’s share capital increased by 10% in November 2012 from a £35.8 million fund raising - which means Goldman’s original forecasts would have been slightly diluted - it still doesn’t excuse the fact that the firm’s earnings profile doesn’t match its valuation. As such, we would stay well clear of the stock.

If you see a stock on a PE above 30, for example - have a look at forecasts for the current financial year and the subsequent year. The second 12-month period may show a big increase in earnings, which means a big decrease in the PE ratio. The issue is whether you believe the earnings forecasts are correct. With Ocado, they clearly weren’t.

Stocks on a high PE are vulnerable to a sudden fall in the share price upon the first bit of bad news. Fashion houses Burberry (BRBY) and software group SDL (SDL) crashed amid profit warnings. More recently, retailer Dunelm (DNLM) has slumped after reporting disappointing growth rates.

Highly rated stocks also need catalysts to keep rising. That typically means analysts having a reason to upgrade their earnings forecasts such as new contract wins, better-than-expected sales or big cost reductions. If trading is merely ‘on track’ then share prices often fall as the market is rarely satisfied with steady performance, unless it is from a business that previously had problems in which case steady can be read as reassuring and thus trigger a rising share price.

4. Low PE ratios - the good and the bad

One of the biggest mistakes in investment is to assume that all stocks on a low PE are cheap, and all stocks on a high one are expensive. The majority of companies on a PE below seven or eight are cheap for a reason. Their debts could be sky high and the market preoccupied with risks of a covenant breach, or investors may simply not believe a company will achieve its earnings forecasts. A low PE may even be caused by operational problems or disruption to its end market.

While it is true that some of the best investments are made when everyone is negative on a stock we would always approach low-PE companies with extreme caution. To be bullish, we’d want to see low-risk earnings, a strong balance sheet and a clear growth opportunity that isn’t reliant on raising lots of money for working capital or acquisitions.

Following a string of earnings downgrades and a lower-than-expected cash payout for a court case, market sentiment has understandably been poor towards engineer Redhall (RHL:AIM). It is a classic example of a low-PE stock where you have to decide whether all the bad news is priced in - or if further troubles lie ahead.

Charles Stanley reckons Redhall’s pre-tax profit will increase by 50% in 2014 to £2.4 million. Based on the broker’s 6.69p EPS forecast, its PE is a mere 7.3, using the latest share price of 48.9p. The following year’s 10.4p EPS puts the stock on 4.7 times earnings. That’s the market saying it doesn’t trust the forecasts and/or doesn’t like the high debt levels. Redhall’s management says there won’t be any big drain on working capital this year because the focus is operational efficiency rather than chasing volumes of work. But £18 million forecast net debt versus a £14.6 million market value is a big turn off, nonetheless. The risks are simply too high.

5. When not to use PE ratios

Loss-making companies will have a negative PE, which is meaningless, so investors should look at other valuation techniques. They could employ the price/book ratio, a price-to-sales multiple or enterprise value to sales ratio if the firm has debt. Some analysts don’t like using PE ratios for financial companies, where the value of their assets is key and the same can apply for property firms which are often judged by the value of their bricks and mortar.

Exploring PE ratios in the retail sector

A glance at the ranks of the food and drug retailers reveals a good many names trading on PE ratios in the high teens, twenties or thirties, with a paucity of companies selling on single-digit multiples. This reflects a reratings tide which has lifted all boats across what is a cyclical sector as investors bet on improving GDP data, rising consumer confidence and a housing market resurgence to boost the ‘E’ in the PE of a host of quoted shopkeepers.

Within food retail, Ocado, the online grocer, trades on 171 times forecast earnings, revered food wholesaler Booker (BOK) on 30.7 times and chocolatier Thorntons, a compelling turnaround now trades on more than 20-times forecast EPS. Polarisation between the hard discounters Aldi and Lidl and premium grocers such as Waitrose, as well as on downgrade concerns, leave major supermarket operators Tesco (TSCO) and Wm Morrison Supermarkets(MRW) languishing on beaten-down earnings multiples of circa 10-11 times. A buoyant housing market partially accounts for the elevated ratings of Topps Tiles (TPT), Carpetright (CPR) and highly-rated homewares leader Dunelm.

Same business focus, different PE

Two fashion retailers trading on high, yet significantly divergent ratings are global online fashion store ASOS (ASC:AIM) and Superdry brand owner SuperGroup (SGP). ASOS’ eye-watering PE of 107 reflects appetite for the web-based wonder’s structural advantages and vast international growth opportunity. The £5.6 billion cap continues to confound the naysayers with stellar growth rates and a meteoric share price rise sustained by earnings upgrades. But its stratospheric rating means any slowdown or execution stumble could be harshly punished. We prefer SuperGroup for international apparel excitement. Its third quarter trading statement (6 Feb) showed the £1.3 billion cap’s sustained positive sales momentum triggering profit upgrades. Though a prospective PE approaching 25 is demanding, confirmation of buoyant sales momentum alongside a fourth quarter update (8 May) could act as a catalyst to expand the rating. (JC)

SuperGroup (SGP)

Share price: £15.99

Market cap: £1.3 billion

Forecast EPS: 64.6p

Forecast EPS growth: 14.5%

Forecast PE: 24.8

High PE - but why?

Chocolatier Thorntons’ (THT) ongoing turnaround under CEO Jonathan Hart’s stewardship has left it selling for over 20 times forecast EPS. Britain’s biggest chocolate maker is in the last year of its three-year transformation plan to ‘Rebalance, Revitalise and Restore’, a push that has reduced reliance on key selling seasons and exposure to the ailing UK high street and driven a sharp rerating. Thorntons trades on 19.2 times forecasts earnings for the year to June 2014. Yet the market is forward looking and given that we’re over halfway through its financial year, 2015 forecasts start to become more relevant. A big uplift in earning is expected in that period, putting the shares on a more reasonable 12.4 times. Products for year-round chocolate gifting are improving earnings quality, while earnings before interest and tax margins are trekking upwards with the help of cost reductions. Self-help success, falling debt levels and progress behind the fast moving consumer goods division drove the rerating. (JC)

Thorntons (THT)

Share price: 151.2p

Market cap: £103.5 million

Forecast EPS: 12.2p

Forecast EPS growth: 55.4%

Forecast PE: 12.4

Low PE - but why?

Struggling department store Debenhams’ (DEB) derating to a PE of 10.4 reflects disappointment with its latest profits warning on New Year’s Eve. Worries surrounding the resignation (2 Jan) of finance director Simon Herrick and potential for further earnings forecast cuts to come are also weighing on sentiment. Poor clothing sales and lower-than-expected online delivery income combined with widespread industry promotions accounted for the latest earnings alert, a weather-sensitive retailer whose gross and operating margins are lower than they were five years ago. Multi-channel growth is a potential rerating catalyst for Debenhams, whose internet sales skipped 27% higher over the 17 weeks to 28 December. Yet the group continues to service the costs of long leases on a 156-strong UK store base, putting pressure on margins and cash. Though Sports Direct International’s (SPD) Mike Ashley is showing interest in and putting pressure on Debenhams, avoid the counter. (JC)

Debenhams (DEB)

Share price: 74.6p

Market cap: £928.8 million

Forecast EPS: 7.2p

Forecast EPS growth: -29.4%

Forecast PE: 10.4

Exploring PE ratios in Support Services sector

The diverse nature of the support services sector means you have to compare like-for-like stocks, rather than simply look for the sector average PE ratio. The mish-mash of recruiters, cleaners, security providers, distributors and rental companies all have different growth dynamics, so valuations will be wide ranging. There’s a mixture of cyclical stocks which can command high PEs; there’s also equities with low PEs because they have poor earnings visibility or are subject to market threats. In the latter grouping are pub monitoring play Vianet (VNET:AIM) and stationery supplier Office2Office (OFF). The names with high PEs are generally market leaders which have an amazing track record of consistent earnings growth, such as Bunzl (BNZL).

Same business focus, different PE

Most recruitment companies command high PEs at present because the market anticipates a new earnings growth spurt thanks to improving economic conditions. Such a backdrop gives companies the confidence to hire and individuals the belief they can find a new job. Robert Walters (RWA) operates in 24 countries and provides white collar workers into such sectors as accountancy, finance, engineering and legal. It trades on 33.5 times prospective earnings for the current financial year which looks far too rich - certainly suggesting the market has already priced in a stronger jobs market. We examined sector peer Hays (HAS) in depth last week (see Griller, Shares 20 Feb), on 17-times forward earnings. Not only is that a more reasonable valuation compared to Walters, Hays also has a great track record of turning job placement fees into profit. As we revealed in last week’s piece, its fee income is three and a half times bigger than Walters’ and profitability 13 times greater.

Hays (HAS)

Share price: 135.6p

Market cap: £1.9 billion

Forecast EPS: 7.97p

Forecast EPS growth: 39.3%

Forecast PE: 17.0

High PE - but why?

Online gambling-to-retail transaction processor Optimal Payments (OPAY:AIM) has risen 700% since we first highlighted the stock’s potential just over two years ago (see Plays, Shares 15 Dec ‘11). There’s been two catalysts. Initially, the market liked the fact that Optimal no longer missed earnings forecasts which was the big problem when it was trading under the previous name of NEOVIA. A PE ratio of 26.8 may look high on paper but we believe there’s still significant upside for the shares, as the reopening of the US online gambling sector has only just begun and Optimal is expected to soon make an acquisition to strengthen its position in Europe. It is a small, fast-growing player in a very large industry and that territory comes with high equity valuations.

Optimal Payments (OPAY:AIM)

Share price: 449.1p

Market cap: £724.5 million

Forecast EPS: 16.7p

Forecast EPS growth: 8.1%

Forecast PE: 26.8

Low PE - but why?

Coal miner-to-haulier Hargreaves Services (HSP:AIM) has one of the lowest PE ratios in the Support Services sector at 6.0. The low rating is down to several factors. The company encountered geological problems which forced the closure of one mine and it suffered fraud in its Belgium business. In October, one of Hargreaves’ big coke customers Tata Chemicals announced plans to restructure its soda ash operations in the UK which creates demand uncertainty. But the over-riding factor behind the low PE is ongoing coal price weakness. Hargreaves continues to expand its coal mining operations, yet long-term coal demand in the UK doesn’t look good. Asian opportunities play to its favour but until there’s further progress overseas, we believe market sentiment will remain poor towards the stock and therefore don’t see a rerating anytime soon.

Hargreaves Services (HSP:AIM)

Share price: 881p

Market cap: £291.5 million

Forecast EPS: 148.0p

Forecast EPS growth: 12.2%

Forecast PE: 6.0

Exploring PE ratios in the technology sector

The technology space is highly cyclical on the whole. Product and services demand ebbs and flows with economic activity. That is reflected in average PE multiples, which can appear racy as revenues and profits play catch-up to the market’s expectations, although there are subtleties below the surface. Roughly two-thirds of companies across the more manufacturing-based Electronic & Electrical Equipment sector are trading above the sector’s average PE of 18, suggesting several companies trading far below mean. This pattern is apparent to an even greater degree in the Software & Computer Services sector, where nearly three-quarters of the names are trading above the average PE of 16.

Same business focus, different PE

Many investors have been drawn into an ‘either/or’ situation with insurance claims outsourcing software suppliers Quindell (QPP:AIM) and Innovation (TIG), and each has built enthusiastic fan clubs. While working to the same insurance industry claims cost cutting objective, Quindell trades on a forward PE of 11.4 compared to Innovation’s 18.4, a rating differential that arguably reflects the market’s established understanding of the latter, but ongoing scepticism of the former. Quindell’s medical treatment operations have been incorrectly, and unfairly, lumped in with unscrupulous, ambulance-chasing cowboy operators and this has proved a hard badge to wear no matter how untrue. The second issue seems to relate to Quindell’s frenetic pace of acquisition which has also sown seeds of doubt in some quarters. These negative perceptions are starting to change and it appears just a matter of time before Quindell rerates. (SFr)

Quindell (QPP:AIM)

Share price: 43.5p

Market cap: £2.6 billion

Forecast EPS: 3.8p

Forecast EPS growth: 58.0%

Forecast PE: 11.4

High PE - but why?

Multi-utility Telecom Plus (TEP) has an increasingly long-run track record of beating expectations. It is now perceived by investors to be so reliable that they have bid up the share price three-fold in three years putting the forward PE at 39 to March 2014, although that falls to 29.1 next year. That may look astonishing for a gas, electricity and broadband supply business yet it is the group’s unique low-cost marketing model and bundled value pitch that consistently pulls in new customers, and then gets them taking more services. Under the bonnet, the racket effect of its deal with nPower has solved past cash crunch issues when energy demand is highest (in the winter) and means that the more customers Telecom Plus recruits, the better its gas and electricity supply terms get. This implies relative security to future trading, the sort of visibility that the market obviously likes, and importantly, is willing to pay a hefty premium for. (SFr)

Telecom Plus (TEP)

Share price: £18.73

Market cap: £1.5 billion

Forecast EPS: 64.3p

Forecast EPS growth: 36.0%

Forecast PE: 29.1

Low PE - but why?

SciSys (SSY) is an odd collection of specialist businesses selling IT systems and services into diverse markets including space exploration, defence and media/broadcast. Yet despite its apparent niches, growth has remained elusive for the company. Revenues have bounced about over the past few years but 2012’s £39.5 million was barely better than the £38 million chalked-up way back in 2008. In fairness, SciSys looks odds-on to report sales of about £43.5 million for 2013 (figures yet to be published) but the crux of the matter seems to be a lack of focus. Valued at just £22 million, it’s arguable that the company is trying to do too much across too wide an ecosphere, and the costly result is limited progress everywhere. With little to seemingly excite investors, and a dividend yield of less than 2%, it’s hardly surprising that investors are reluctant to pay a premium, with the shares currently trading on a 2014 PE of just 9.2. (SFr)

SciSys (SSY)

Share price: 76.0p

Market cap: £22 million

Forecast EPS: 8.2p

Forecast EPS growth: 5.9%

Forecast PE: 9.2

Exploring PE ratios in the engineering sector

The UK industrial engineering sector has performed strongly since the end of the 2007/8 recession outperforming the wider market and US peers. A combination of upgrades and a more gradual rerating as the market has switched on to enhancements in the quality of the engineers’ earnings profile, have supported this upwards move. Lean, technologically focused companies operating in a diverse mix of geographies have replaced the low-margin metal bashers which dominated the sector in the 1990s. The net result is that a number of companies are on lofty looking multiples and the engineering sector as a whole trades on an average 16 times 2014 earnings according to Numis.

Same business focus, different PE

Although both companies are engineers, machine tool specialist 600’s (SIXH:AIM) PE is less than half that of its larger peer Spirax-Sarco (SPX). While this might have investors rubbing their hands it is important to understand there are good reasons for the disparity. Yorkshire’s 600 makes and distributes machine tools, precision engineered components and laser marking systems. It’s financial results have shown considerable volatility. In the March 2010 fiscal year it racked up losses of £8.8 million and then swung to a March 2011 profit of just under £3 million. It slipped back into the red with a £15 million loss for March 2012 before recovering to a March 2013 profit of £4 million. We believe 600 may have some recovery potential (see Plays, Shares 13 Feb) but Spirax looks by far the better long-term play despite apparently being more expensive. The Cheltenham firm, which specialises in steam control equipment, has a much higher quality earnings profile. (TS)

Spirax-Sarco (SPX)

Share price: £30.50

Market cap: £2.3 billion

Forecast EPS 50.5p

Forecast EPS growth: 8.3%

Forecast PE: 20.3

High PE - but why?

Bath-headquartered Rotork (ROR) makes valve actuators - devices which manage the flow of liquids, gases and powders - for large industrial customers with a particular bias towards the oil and gas sector. In 2012 oil and gas accounted for a little over half its revenues. Its niche focus has helped it build a consistent track record of outpacing market expectations. Numis notes Rotork has posted higher growth levels than its forecast in each of the last 10 years. An order book of £204.8 million provides some ballast but spending cuts in the oil industry are a risk worth bearing in mind in 2014 when considering the premium rating. The reaction to Rolls-Royce’s (RR.) warning of flat revenues and profits this year is a reminder of what happens when a quality growth stock fails to deliver. Rotork will need to confirm it is on track to at least maintain its current rate of expansion when it reports on Tuesday (4 Mar). (TS)

Rotork (ROR)

Share price: £25.80

Market cap: £2.2 billion

Forecast EPS: 126.9p

Forecast EPS growth: 4.0%

Forecast PE: 20.0

Low PE - but why?

Taking a view on Molins (MLIN:AIM) means understanding the risks associated with its ongoing pension liabilities. The company makes machinery for the tobacco industry and also tests harmful compounds for cigarette makers through its scientific services business. On the basis of its PE the company looks cheap but its UK pension liabilities (£333 million at the last count) dwarf the £32 million market cap. In mitigation it should be pointed out that the company is far from unique in this regard - a number of listed firms face this potentially toxic legacy - and the associated costs have not prevented Molins from consistently increasing its dividend. Some kind of discount is inevitable but a 53% shortfall on the sector average looks excessive. Particularly as CEO Dick Hunter is looking to build out the higher margin scientific services business. (TS)

Molins (MLIN:AIM)

Share price: 157.5p

Market cap: £31.8 million

Forecast EPS: 22.2p

Forecast EPS growth: 4.7%

Forecast PE: 7.1