p/e Ratio and its significance

This is my first blog and I will try to keep it simple. For a start, I will write about a basic concept on the subject of Corporate Finance. 

During our accounting module in the MBA we learnt about the various ratios that could be calculated using the figures from a company account. These ratios when compared with different companies and across time periods give an indication about the relative performance of the company. Today we'll look at the p/e ratio and why is it so important. 

The p/e ratio is basically the current price of a share divided by the earnings per share. This, in principle, is same as the equity figure from the balance sheet divided by the total earnings.

Thus,

p/e = (current share price/ earnings per share (eps)).

From a shareholder’s perspective, the return on the investment is either in terms of dividends or capital gains or a combination of both.

The share price, which reflects the potential capital gains, represents the future growth potential (see: what does the share price convey?).  Thus a higher share price means that investors think there are significant growth opportunities for the company in the future.

The ‘earnings per share’ indicates the current profitability of the company.

Thus the p/e ratio then means how much is one willing to pay for each £ of earnings. Higher the number, expensive the investment!

I’d like to make two points straightaway:

1.       High p/e ratio means the market considers that the company has a high growth potential. The management of the company might want a high p/e multiple, but this also places that much extra pressure on the management to achieve the higher growth.

2.       The company’s perceived (perceived by investors) risk profile is inversely manifested by the p/e ratio.  i.e. higher p/e reflects a lower perceived risk. (see: mathematical proof using the DGM model)

We know that companies cannot grow at the same rate forever. A start-up will generally experience a fast growth rate after which it enters a ‘maturity’ phase and its growth rate declines (see: Boston Matrix). Since we know that the share price reflects the future growth potential (see: steady state and PVGO), the growth rate in the share price will decline (note this is the growth rate in the share price NOT the share price, which may still grow) as the company enters the ‘maturity’ phase.

This means a declining p/e ratio. To avoid this and apparently to remain attractive to investors, the directors of the company start diversifying into new areas to create opportunities of future growth. However, investors may not like unrelated diversification; they may prefer to invest in diversified stocks themselves instead! For one thing, the directors of the companies might not know the tricks of the trade of the new product/market they are entering. This implies higher perceived risk and hence a lower p/e ratio.

Although the argument just presented makes it seem that the p/e ratio is a good indicator for investment, I would like to caution my readers:

1.       A p/e ratio need to be looked in comparison with other companies in the same industry and even across industries and maybe FTSE 100. There are several other factors (other than just numbers) that might be worthwhile to consider before investing.

2.       The eps in the p/e ratio is an accounting number which is only as good as the accounting standards of the company under question.

Thank you for reading.

Comments/ Suggestions are very welcome!