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A Deeper Look at the Price-To-Earnings Ratio: Part 1

One way to know if a stock is cheap or expensive is by looking at its price-to-earnings (PE) ratio. Let us take a deeper look at this ratio today and how we should apply it when we evaluate our investments.

So let’s say we have companies A and B. A has a PE ratio of 10 and B has a PE ratio of 5. Would it make a difference to you if A is a cloud computing company and B is a brick and mortar retailer? Of course it would.

Gartner has forecast that the worldwide public cloud services revenue will reach US$411 billion in 2020 from US$220 billion in 2016. This is a CAGR of nearly 17%. Brick and mortar retailers globally have generally lost market share steadily to online shopping. PE ratios can and often are industry specific.

Now what if both companies A and B are in cloud computing but A is a small company that had just gone public? Let’s say A has a revenue stream of $10 million in 2018 and B, $100 million. A is forecast to grow its earnings by $2 million in 2019 and B is forecast to grow by $5 million. Which company is ‘cheaper’?

Year 2018 Company A Company B
Equity Value  $10,000,000  $100,000,000
Earnings  $1,000,000  $20,000,000
PE Ratio 10 5
Year 2019 Company A Company B
Equity Value  $10,000,000  $100,000,000
Earnings  $3,000,000  $25,000,000
PE Ratio 3.33 4

We can see from the two tables above that in 2019, Company A’s PE ratio is now lower than Company B’s. Now, many assumptions have to be made for the calculations above but what should be appreciated is small companies grow relatively faster than large companies because they have a smaller revenue base to start with. What may be a ‘cheaper’ company today may not be a ‘cheaper’ company in the next 10 years.

Ratios are only meaningful when we compare apples with apples. What provides a context for such comparison would be factors such as the country of listing, the industry PE average and also, the stage of growth both companies are in.

What drives the value of a company (and its share price) is its ability to earn. When you buy a share, you are paying for future earnings, not historical ones. When two similar companies have different PE ratios, it means the market has valued both companies differently given past performance and future expectations. We must understand why this is so is much more important for investing than saying one stock is cheaper than the other.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice