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How You Can Invest More Effectively

As an investor in shares, it’s important to understand that each share represents a partial interest in a living, breathing business and consequently, it’s important to understand how to value a business. In so doing, you can then invest more effectively.

To value a business, one of most commonly used metrics would be the Price to Earnings Ratios (P/E).

How is the P/E ratio related to the business?

One of the main components that can affect the P/E ratio attached to a business would be the growth rate in its earnings. Often, we are able to see that a company that has displayed a high rate of growth in earnings would tend to trade at a high P/E ratio; conversely, most low P/E companies are experiencing much slower rates of growth.

We can see this happening in the market with shares like Raffles Medical Group (SGX: R01) and Keppel Corporation (SGX: BN4).

Raffles Medical Group

Keppel Corporation

CAGR in earnings per share over past 5 completed financial years*

21%

3%

Trailing earnings per share

S$0.156

S$1.01

Current share price

S$3.58

S$10.58

P/E ratio

23

10

*CAGR = Compounded annual growth rate

Source: S&P Capital IQ

Raffles Medical Group, with its much faster earnings growth rate of 21%, carries a P/E ratio of 23. Meanwhile, Keppel Corporation, whose earnings growth is much slower at just 3%, has a P/E ratio of just 10.

How to use the P/E ratio effectively

There are two ways to use the P/E ratio. We can either compare the P/E ratio for different companies across the same industry, or we can compare the ratio for a single company across time to find the range in which it would generally trade in.

In the first type of comparison, if a company has a P/E ratio below the average for its competitors within the same industry, it might be a sign that the company’s undervalued. On the other hand, a P/E ratio on the high end of the scale in relation to the rest of its peers might signal that a company’s overvalued.

As for the second type of comparison, if a company’s trading near its historically low P/E range, that could be a sign that it is currently undervalued. The reverse is true as well – a company near its high P/E range is possibly overvalued.

Foolish Summary

While the P/E ratio can be a very useful tool to help you invest more effectively, there’s one important caveat to note when using it to compare different companies within the same industry: Different companies might adopt different accounting treatments for their financials, hence creating a situation whereby it’s not always an apple-to-apple comparison.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim doesn’t own shares in any companies mentioned.