Spotting potentially undervalued investment opportunities before the rest of the market herd has its obvious attractions.
The market uses any number of valuation techniques, but even so, valuing a stock, investment trust or fund remains highly subjective, and often it comes down to a matter of opinion.
Nevertheless, having a basic valuation tool kit is hugely important for investors. We are going to concentrate on some of the most popular ones, today a give a basic run through of the price to earnings ratio, or PE for short.
We will follow up next week with a second part which will spin through the PE’s sister metric, the PEG, or price to earnings growth, plus take a look at book value.
GET TO KNOW YOUR PE FROM YOUR ELBOW
A price to earnings ratio, PE multiple, is commonly used to assess the level of confidence investors have in a company.
It represents the market's view of a company's growth potential, and how it is being valued by the wider investment community.
By comparing PE ratios between companies and across business sectors, investors hope to identify undervalued stocks.
HIGHER OR LOWER
A high PE indicates that investors have a high level of confidence in a company's future prospects. But while a company with a high PE ratio relative to its sector may have exciting growth prospects, it might equally be considered to be overvalued depending on prevailing market circumstances.
Equally, a very low PE could be justified for a good reason. Perhaps the market simply does not believe revenue, profit and earnings forecasts in the public domain. It could mean that investors have severe doubts about cash flows or dividends, say.
USEFUL, AS PART OF WIDER VALUATION ASSESSMENT
So while PE can be a useful measure of a company's value, its use in isolation should also be treated with caution.
PE ratios vary dramatically between companies and sectors. For example, companies with exciting growth potential from the development or use of new technology tend to command higher PEs.
RULE OF THUMB GUIDE
As a useful rule of thumb (and only a rough guide) investors might consider the following:
PE 25 or higher = very racy, high growth or very reliable earnings streams, or simply overvalued
PE 18-25 = high, good quality company, high growth or very strong cash generation and dividends
PE 12-18 = reasonable, could be good upside share price potential, depending on growth, reliability, industry trends
8-12 = cheap, businesses likely to be struggling for much growth, have a patchy performance track record, or undervalued
Below 8 = dangerous, when the rating is this cheap-looking it is very often for good reason, poor track record, little faith in forecasts, may need fresh funding
Negative PEs tell you little more than that the company is loss-making, and they should not be used as a valuation tool.
The PE is simply the share price divided by the after-tax earnings per share (EPS). EPS is worked calculated by dividing a company's 12 month earnings by the number of shares in the market.
Like most performance indicators, the PE works best if it is monitored over a length of time, that way it is possible to discern a trend rather than relying on a snapshot of a given moment.
