Are you a value investor?
Maybe you wouldn't call yourself that specifically, but most investors are looking for a good deal.
A key element of investing is understanding value. Determining whether the current share price represents an over or undervalued proposition can really help with decision making. Furthermore, understanding value can help remove some emotion (I said some, we love what we love!)
How do you determine this value?
Analysts use financial ratios to determine value compared to the market. Once you understand financial ratios, you can use them to compare a company not only to the market, but to its competition.
One ratio that can help you to do this is the price-to-earnings (P/E) ratio.
I should note here that analysts use many ratios to determine value. This is the one I would personally go to first.
Let's dive in.
Price-to-earnings ratio
The P/E ratio is one of the most widely used ratios in financial analysis. Not only does it reveal whether a stock is over or undervalued, it can also be used as a benchmark. Measuring a company against its competitors, the industry or an index is very useful.
What does it mean?
This ratio tells us what the market is willing to pay today for a share, based on its past or future earnings. High P/E ratios tend to indicate overvaluations. Low P/E ratios can represent a buying opportunity or an undervalued company. This is a broad definition.
When it comes to shares, we need to consider the type of company we are looking at, the industry it's in and how fast it's growing.
For example, a tech share might be growing rapidly with with huge future potential, so the P/E ratio can seem high. However if you were to dig a little deeper, you might find the reason for the high ratio. This company may be the next Facebook, Inc (NASDAQ: FB) or Afterpay Ltd (ASX: APT). If investors think this might be the case, they may be willing to pay more than 'market value' in the anticipation that future value will be much higher. In other words, they don't want to miss the boat.
Calculation
The P/E ratio is calculated by dividing the market value per share by the company's earnings per share (EPS).
P/E = share price/EPS
Example
Commonwealth Bank of Australia (ASX: CBA)
EPS – $4.31
Share price – $69.09
P/E = 69.09/4.31
P/E = 16.03
CommBank is trading at roughly 16.03 times earnings.
Meaning and comparison
Now we have this ratio for Commonwealth Bank, we can use it to compare the banking giant to its competitors, the industry and the market.
I have done some calculations in the background.
- National Australia Bank Ltd (ASX: NAB) – P/E = 15.3
- Australia and New Zealand Banking Group Limited (ASX: ANZ) – P/E = 11.1
- Westpac Banking Corp (ASX: WBC) – P/E = 12.8
- Average of big four publicly listed banks – P/E = 13.81
- Average of top 10 Australian publicly listed banks – P/E = 10.89
As an investor looking to buy banking shares, you now have the first indication of value.
We can see from the list above that Commonwealth Bank has a much higher P/E ratio than its major competitors and also the industry.
Does this mean that you shouldn't buy Commonwealth Bank shares now? No it doesn't. It means you know that they are valued higher than the relative market.
Where to find information
The ASX website is the most official source of company ratio information. However, this is a case in point worth noting. At the time of writing, the ASX website listed the P/E ratio of Commonwealth Bank to be 12.68. Upon checking the data, I discovered the correct ratio was 16.03. The ASX website may not update daily, so it's valuable to understand the mathematics behind a ratio in case you prefer to check it manually. Many websites and software platforms readily provide ratios at the touch of a button as well.
Related ratios for determining value
The P/E ratio is the number one ratio I personally start with to determine value, however there are a number of other ratios worth exploring if you are mathematically inclined. These include:
- Price earnings growth ratio – PEG
- Next year projected P/E ratio – FPE
- Price-to-sales ratio – P/S
- Price-to-book ratio – P/B
Foolish takeaway
Ratios are by no means the only way to value a company. So many things need to be taken into consideration, however they are a great place to start. Numbers don't lie (well, most of the time) and they can help investors to make unemotional decisions.
Comparing this process to property investment, ratios are like bench marking with price comparisons. If you love a 3-bedroom house for sale at $800,000, but every other 3-bedroom house in the area is listed at $500,000, you are going to want to know what makes this house so special.
Companies are no different. The more assessment you can do for a potential investment, the better!
