P/E - Price/Earnings Ratioveryard projects > notions > p/e
|meaning||use||on this page|
|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.
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|
Fallacy: Confusing Cause and Effectveryard projects > notions > p/e > cause/effect
|High expectations of future profits||High demand for shares||High share price||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.)
Background - How Stock Markets Workveryard projects > notions > p/e > background
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
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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