After introducing EBIT last week, in in part two of Beyond the Jargon, I’ll be explaining PE and PEG ratios – likely the most quoted terms in finance. However, despite its wide use, the PE ratio remains a divisive topic. Some deride the PE ratio and its variants as ‘useless twaddle’, whereas many others find it a helpful tool. I believe the truth, as usual, lies somewhere in between.
Alternative phrases: Price to earnings ratio, PER, p/e.
Short explanation: A quick and easy way of comparing the prices of different stocks or markets. It divides the share price (p) by the earnings per share (e). A lower value indicates a lower price, or higher earnings.
The PEG ratio is an extension of the PE ratio, where the PE is divided by the annual growth rate. The principal being that it’s worth paying a higher price for a faster-growing company.
More detail: As Warren Buffett says, “Price is what you pay, value is what you get.” The first thing to understand about the PE ratio is that it tells you nothing about value, it’s a tool that can be used to compare prices.
“I have no use for P/E ratios. P/Es can’t tell you very much about whether stocks are cheap or expensive other than in the most crude and rudimentary way.” – Roger Montgomery
As companies have different numbers of shares on issue, comparing the share price of two companies is entirely redundant. Using a PE ratio means that you are at least comparing ‘apples to apples,’ even if the comparison is overly simplistic.
Often there is a good reason a stock is ‘cheap’ on a PE basis, especially when looking at historical PEs. Historical PE ratios fail to account for any expected positive or negative changes, in fact for cyclical businesses, they often have the highest PE at the bottom of the cycle, and the lowest PE at the top.
While forward PE ratios may appear to solve this issue, they are only ever estimates and should be treated with appropriate scepticism. To quote Warren Buffett again, “Forecasts usually tell us more of the forecaster than of the future.”
However, this isn’t the full story. Over the long-term, statistical analysis has suggested that PE can be a useful predictor of returns at a market level.1
“According to our work, the simple P/E ratio explains a significant portion of longer- term stock market returns. On the other hand, P/E ratios have little explanatory power for holding periods up to 10 years.” – Brian Belski, Chief Investment Strategist at BMO Capital Markets.
While the PEG ratio does account for growth, don’t be fooled into thinking that it’s an indicator of value. When management invests below its cost of capital2, growth will destroy value, rather than creating it.
Like any tool, the PE ratio and PEG ratio can be helpful when used appropriately by someone who understands its limitations, but when misused, it can be dangerous.
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1. Source: (VIEW LINK)
2. Cost of capital will be explained in a later entry of Beyond the Jargon.
Patrick was one of Livewire’s first employees, joining in 2015 after nearly a decade working in insurance, superannuation, and retail banking. He is passionate about investing, with a particular interest in Australian small-caps.