How to value stocks (Basic): Using P/E Ratio

Part II of our common stock valuation (basic) talks about the popular price earnings ratio.

If you've missed Part I of our Basic Common Stock Valuation using Book Value, click HERE.

P/E Ratio tells a lot about the profitability of the company relative to its price or relative to what you're paying for.

In real estate it is similar to cash-on-cash return, although technically you don't recieve 100% of the profits in cash, as you only receive the cash as dividend.

P/E ratio tells you how much corporate earnings you get for the price of the business you're paying for.

P/E Ratio is also called the "earnings multiple" since it is the price you pay divided by the latest earnings per share figure. Hence, it shows the number of times of corporate earnings at that price.

For example, a P/E Ratio or earnings multiple of 8 means that the current price is 8 times the company's latest earnings.

Sir Aya Laraya considers the P/E Ratio as the number of years you are going to get back 100% or all of your original investment. You can say that it is the number of years before you double your money in a stock.

For example a company earns P20 per share. The current market price is P100 per share. Hence, the P/E Ratio is 5 (Price: 100 / Earnings: 20 = 5). He is saying that in 5 years, with earnings being constant, you will be able to get back your original P100 investment. Why?

You buy this stock for P100. Every year the company earns P20. That is 20% per year return on investment for your P100. Every year, you would have earned, P20 and another P20.. And so on. After 5 years your company would have made P100 of earnings on top of your original P100 purchase price for the stock/company. You would have gotten back 100% of your investment or doubled your money.

In his book Security Analysis, Benjamin Graham discussed the P/E ratio in relation to simply getting the percentage of earnings for the purchase price or E/P.

For example, using the above hypothetical example, a company with a P/E ratio of 5 has 20% earnings  or 20% ROI (return on investment) at that current price. This relationship between P/E and E/P(%) is constant.

P/E ratio is inversely proportional to the ROI or percentage earnings of the company.
The higher the P/E ratio, the lower the earnings. The lower the P/E ratio, the higher the earnings.
For example:

In a company with a P/E ratio of 20 = you get 5% earnings per share for every peso you pay for the company.
100% divided by P/E of 20 equals earnings of 5% per year (100% / 20 = 5%).

In a company with a P/E ratio of 10 = you get 10% earnings per share
100% divided by P/E of 10 equals earnings 10% per year )100% / 10 = 10%).

In a company with a P/E ratio of 5: you get 20% earnings per share
100% divided by P/E of 5 equals earnings of 20

If you choose to buy stocks below a P/E ratio of 10, it means that you are getting at least 10% of the earnings on the price you are paying for the company.

*The higher the P/E ratio, the more expensive the stock is. The lower the P/E ratio, the better.