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P/E - Price/Earnings Ratio

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You will find the P/E ratio quoted next to the share price and dividend yield in the city pages of most newspapers. It represents the value of the shares expressed as a multiple of the value of earnings. If the P/E is high, it means that investors are happy to buy shares at a relatively high price because they expect earnings to increase.

In sectors such as minerals (mining, oil) and technology (software, pharma), there are many small companies that focus on exploration or R&D.
These companies typically have no earnings, or trivially small earnings, and their value lies in the possibility of huge earnings at some future date. For companies like these, P/E ratios are practically meaningless.
We may use the P/E ratio as an indicator of perceived viability. However, we should be careful not to see it as an indicator of actual viability.
Example: BSkyB

You can sometimes find different P/E ratios for the same company, based on different measures or estimates of earnings (this year, next year). This can cause problems if you are combining information from different sources.
Fallacy: Confusing Cause and Effect

Background - How Stock Markets Work

veryard projects - innovation for demanding change

Fallacy: Confusing Cause and Effect

veryard projects > notions > p/e > cause/effect

High expectations of future profits right arrow High demand for shares right arrow High share price right arrow High P/E ratio

A high P/E ratio is a sign or indicator of high expectations. It is not generally a cause of high expectations in the company.

Generally, as share prices rise, fewer investors are willing to buy, and more investors are willing to sell. Thus share price increases are normally self-limiting. (There are some apparent exceptions to this, largely based on the behaviour of speculators, especially those who practise so-called momentum investing, which involves betting on the continuation of recent price movements. However, this is merely based on a prediction of short-term share price movements and does not represent a judgement about the underlying viability of the company.)

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Background - How Stock Markets Work

veryard projects > notions > p/e > background

In the UK, there are several stock markets – the main Stock Exchange, plus some smaller exchanges for smaller companies (e.g. AIM and OFEX). In the USA, NASDAQ operates as a rival stock market to the main New York Stock Exchange. Some very large companies are quoted in more than one stock market – this is known as dual listing. For example, BSkyB is listed on both the London and New York Stock Exchange.

A company typically enters the stock market through an Initial Public Offering (IPO) which sells shares to institutional and/or private investors. Shares are then bought and sold by investors, without reference to the company itself. When a company wishes to raise more capital – for example, to fund a major investment or acquisition – it may issue more shares. Conversely, when a company has more capital than it needs for investment, it can return capital to shareholders either by paying a dividend to shareholders or by buying back shares. Companies often give shares or share options as rewards to directors and key staff. A company is interested in the share price because it affects the economics of these transactions.

Furthermore, company directors have some additional reasons for paying attention to the share price. Firstly, they typically own shares or share options themselves, and their personal remuneration can be linked to the share price. Secondly, they are ultimately elected by the shareholders, and shareholders typically judge directors according to their record of maintaining and enhancing share prices. (In the past, the shareholder votes have often been a formality, but several recent events indicate a growth in shareholder power.)

For acquisition purposes, a company is cheap if its market capitalization (equals share price times number of shares issued) is significantly less than the potential value of the target company to the acquiring company. Thus a low share price may trigger interest from potential acquisition. But if the share price is low because the company is weak, then it may be of little value to anyone. (Why buy out a competitor, if they are going to go bust anyway?)

But don’t equate acquisition with failure. When an undervalued but viable company is acquired, the shareholders are richly rewarded for their patience, and the directors often get excellent jobs or golden handshakes. For many small high tech companies, the ultimate success would be acquisition by IBM or Microsoft.

Some companies issue a large number of low-denomination shares, while other companies issue a smaller number of higher-denomination shares. So the fact that one company has a higher share price than another tells us nothing. What is much more significant is that one company’s shares are rising, while another’s are falling.

Share prices have both long-term and short-term movements. In the course of a week, the share price of a large company’s shares may go up and down dozens of times, as people buy and sell the shares. The newspaper often shows the price movement of the share from one day to the next. While some stock market speculators can make large profits or losses from day trading, these short-term movements are usually of little significance to the company itself. If BSkyB shares went up 1% yesterday, while ITV shares went down, this may be just random noise. But more significant to the company are the
longer-term trends. Over a 12-month period, the shares in a successful company can go up three- or fourfold, while shares in an unsuccessful company can collapse. If BSkyB shares go up 1% every week, while ITV shares go down every week, this is more than just random noise.

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This page last updated on July 14th, 2004
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