Monday, May 15, 2006

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.