Price Earnings Ratio, PER, P/E Ratio

How do you actually measure the cheapness of a stock? SMRT shares trade at $1.40 and NOL trades at $3.00, is SMRT cheaper than NOL? The answer is a big NO. The price of the stock does not tell you whether it is cheap or not. Sadly, I would say 99% of the 1st-time investors never knew how to calculate the value of a stock when they first started investing. And needless to say, they also never heard of the all-important P/E ratio.

The P/E ratio is the most widely used yardstick to value a stock (i.e. to see if the stock is cheap or expensive). It is simply the price of the stock divided by its earnings per share. E.g. SMRT trades at $1.40 today, and its expected EPS for 2007 is $0.08, if you divide $1.40 by $0.08, you get SMRT's P/E ratio which is 18x.

PER tries to determine the value of a product by dividing its price by its quality. Here the quality of the company is determined by how much money it makes.

To give a simple analogy, Car A and Car B sells for $10,000 and $20,000 respectively. (ok I know this is ridiculous, the cheapest car in Singapore sells for $30,000 and it is made in China, but this is just example, ok, example.) Car A saves $200 of petrol per year while Car B saves $500 of petrol per year after driving the same distance. Which is a cheaper car?

Answer: Car B, because the Price / Petrol Savings is lower for B ($20,000/$500 = 40) than A ($10,000/$200 = 50). Similarly, a stock with a lower P/E ratio is cheaper stock, because for a certain price, you are getting better quality (i.e. the company generates more earnings). Historically, P/E for major markets have fluctuated from 10 to 40. (40 during the IT bubble). P/E ratios of individual stocks can be as low as 2 or 3. This simple but effective rule has been proven to make money over the long run.

The P/E ratio might be the single most important no. in investment as it gives an investor a quick and fairly accurate sense of how much a company is worth. Over the years, analysts and academics developed other valuation metrics like EV/EBITDA, EVA (with a copyright) PEG ratio etc, but nothing beats the simplicity of P/E. Surprisingly, most retail investors probably never heard about this when they buy their first stock and mainstream business news fail to mention this important ratio most of the time.

See also Price to Book
and Financial Ratios