Sophie Lund-Yates 7 February 2019
Like any purchase, it’s important to think about value for money when you invest. But what’s ‘good value’ when it comes to buying shares?
Analysts often use something called a price to earnings ratio (P/E).
What exactly is a P/E ratio?
A P/E ratio effectively tells you how much the market’s willing to pay per £1 of company earnings. It’s calculated by taking the share price and dividing it by the earnings per share. You can find a company’s P/E ratio on our factsheets.
If a company is trading on a P/E of 20, it means investors are paying £20 for £1 of profits. If the share price doubles, but earnings stay the same, the P/E would be 40. You’re paying twice as much for £1 of earnings.
So, instinctively, a lower P/E appears more attractive.
How do I know if a P/E ratio is high or low?
This isn’t an exact science, since every company is different. For example, the average P/E ratio of the FAANGs (Facebook, Apple, Amazon, Netflix and Google’s owner Alphabet) is 75 times earnings, because they’re expected to increase profits quickly. But for more mature, less ‘exciting’ businesses, P/E ratios tend to be lower. For example, British Utilities companies are currently trading on more like 17 times on average.
To understand if a P/E is high or low, it’s best to look at the longer term average for the specific company and its peers. We suggest looking at an average of no less than five years. It can be hard to find this information in the public domain, but you can sign up to our share research to get timely, more in-depth information on specific companies.
Should I always aim low?
A lower P/E can mean you’re paying a more reasonable price for a company. The share price is low compared to the earnings. Choosing investments based on the belief they’re undervalued is known as value investing.
This can reap rewards. If the price you pay for shares is low and the company comes back into favour, the shares should rise in price, although there aren’t any guarantees, they could also fall.
But, just like at a car dealer, buying something that looks cheap isn’t always a good idea.
A very low P/E is often a sign the market doesn’t have much confidence in the long term potential of a business. There’s no point buying shares in a company that’s almost certain to fail just because it looked like a bargain.
That’s why it’s important to focus on the value of what you’re getting as well as the price you are paying. We prefer high quality businesses you can hold for the longer term, rather than being drawn in by a very low price. If a P/E ratio looks too good to be true, it probably is.
So, higher is better?
A higher P/E ratio can be a sign of confidence from the market. Investors are willing to pay more because they believe in the long-term earning potential of the business.
Over time, a higher P/E ratio can mean a better outcome for investors – despite the higher initial cost. Take the following example company:
Price – 100p
Earnings per share – 4p
P/E ratio (Price ÷ earnings per share) – 25
If the company can grow earnings per share by 20% for the next five years, to almost 10p, the equivalent P/E ratio obtained will have lowered to just ten times earnings.
On the whole, if you pick a company that can keep growing, it’s worth paying a bit more at the start. Picking stocks in this way is known as growth investing – focusing on future prospects rather than purely price.
That’s not a hard and fast rule though. Very high P/E ratios come with some risk. If performance falls short, highly rated stocks will be punished more than others, since prices are built on high expectations.
This is common with companies that are subject to lots of ‘hype’. If the underlying business isn’t strong, the high P/E ratio can be bad news.
As with anything, if it looks extreme, proceed with caution and seek advice if you are unsure.
What does all this actually mean?
A key message for investors is that price and ratios are only one part of the equation. It’s also important to look at earnings, and the future of those earnings, along with your own attitude to risk when deciding whether a share is good value or not and whether it is suitable for your circumstances.
As legendary investor Warren Buffett is fond of saying, “price is what you pay, but value is what you get”.
This article like our research is not personal advice, if you are at all unsure of the suitability of an investment for your circumstances you should seek advice.