Is it true that if company X has a PE ratio of 10 means the stock is cheap? What if there’s company Y who’s trading at 11 times its earnings, is it expensive? Then there’s company Z who’s priced only 5 times earnings, is it a no-brainer deal?
What is PE ratio? Why is it sounds like a magic ratio that tells you which stock to buy in any given situation?
The Price-to-Earning Ratio (P/E or PE) is the ratio used to assess a company based on its current stock price and net income. The PE ratio is also often referred to as earnings multiple.
If you think about it, this ratio often comes up when discussing a stock.
Financial websites, stock forums, news, and even social media comments. Unfortunately, PE ratio is often misunderstood by novice investors. Just by comparing the PE, you already had enough information needed to buy shares.
The truth is, this ratio is only able to tell very little to no about the company you’re trying to buy.
PE ratio is often brought up for fundamental analysis. Basically, the ratio is made as a comparison between one company with another company.
Many will agree that using PE as a stand-alone indicator is problematic. How can you tell the ins and outs of the business story in the future, just by comparing its current price to its current earnings?
Few Understand this Truth about PE Ratio
When you want to buy a stock in an online trading platform, you’ll be presented with a bunch of key stats about the company.
A number came from literally the company’s Price divided by Earnings at the given time.
Imagine this.
Suppose there is a grocery store called Store A, that’s able to generate 5 million a year in earnings. The owner told you that you would have to pay an amount of 50 million if you want to purchase the whole store.
That makes the PE ratio of the grocery store to be 10x.
So assuming a stable 5 million in net profit per year, it will take you 10 years to break even.
Does it tell you the price of 50 million is cheap or expensive? Hell no.
How can you tell, then? You know the store is priced at 10 times its earnings. But should you buy it right away?
This is a question that is impossible to answer if you only rely on one ratio from a business. At the very least, even if we only rely on PE, we have to put other businesses’ PE as a comparison.
Let’s bring in the second Grocery Store. We’ll call it Store B.
Store B, run the exact same business model as Store A, but is priced at 70 million. So the PE ratio is at 14 times.
Could you now answer these questions?
- Is store A a bargain compared to store B? Yes, we can tell that store B is 30% higher than store A.
2. Which store offers the best deal? I’m afraid I couldn’t tell.
PE is about comparing the prices of assets, with the intention of finding bargains. But the key point is, both of the assets should be comparable.
Lower PE wins by absolute value, but it doesn’t tell you anything about relative valuation. Because most of the time, when you compare two or more assets using relative valuation, you’ll pick the one with higher PE ratio.
A fresher store with the opportunity to pull off incremental growth wins over an older store that has already stopped growing, by miles.
Therefore, a store with more growth prospects and a promising consumer base should be priced higher than a store with low to no growth opportunity.
Golden Opportunity that Most People Missed
As an Indonesian who trades stocks in IDX, I’m gonna use one of my favorite companies as an example. By giving you the best example I can come up with.
PT. Ultrajaya Tbk. (ULTJ) from consumer sector is the industry leader in fresh milk market.
On April 15, 2016, ULTJ trades for Rp998,- per share and priced at a 22.2 PE ratio, net profit was Rp45,- per share. For most self-proclaimed value investors, a P/E of 22 times is a big no. Many chose to leave on the spot and try to find better offers. It actually did happen in 2016, when most “value investors” didn’t even batted an eye to ULTJ.
“With Rp45,- earnings per share and Rp998,- per share, the PE is already 22.2x. The PE does go through the roof!”
Little did they know, that 5 years from there, things won’t be the same anymore.
At the point when I first created this analysis, ULTJ was trading at 1,540 rupiahs per share, and the PE was 13.7, meaning that in 5 years ULTJ has increased its earnings by 150% from Rp45/share to Rp113/share. That’s a 20% increase per year!
If you dig down the numbers, you’ll notice that even though the earnings have been increased by 1.5 times, the price per share only increased by 54%.
The earnings have outgrown its price. Consequently, drag down the PE ratio from 22.2 to just 13.7!
If, in 2016 you choose to buy ULTJ at Rp998/share, and you keep your ownership until the beginning of 2021 when ULTJ disclosed their profit to be Rp113/share, it’s safe to say that you bought a stock at only 8.8 times its earning. What a deal.
Had anyone believed that ULTJ’s PE is too high in 2016, nobody would enjoy this rare opportunity the stock market gave them.
And that’s why PE ratio was not a “thing,” especially when you mistakenly use it to decide a buy or bye situation for every company.
Think wisely.
Don’t get fooled by a random ratio.