PE ratio is a very common ratio used within the stock investing community regardless of whichever country you reside be it Malaysia, Singapore, Hong Kong or Vietnam to name a few. Used correctly, this ratio can tell the investor if it is the perfect timing to invest in a stock. However, very few investors actually understood what it is let alone what it represents.
What is a PE Ratio?
PE Ratio or Price – Earnings Ratio is defined using the formula below:
It simply compares that price of every share to the income generated per share. In general, the PE ratio on its own tells us how many years it would take us to breakeven on our investment should the company generate the same amount of money every year. For example, if the PE Ratio of a stock is 10x, in theory, it should take us 10 years to breakeven on our investment and every year after that is pure profit. Therefore, as you can tell, the lower the PE Ratio, the more attractive the investment is. However, that is only true if you purchase the entire company and if the income generated by the company is the same every year. Therefore, in a dynamic environment such as the stock market, this ratio is used differently.
Here are 3 common ways investor use the PE Ratio to make investment decisions:
1. Historical PE Ratio
One way the PE Ratio is evaluated is by comparing the current PE Ratio of the company to its PE Ratio in the past. So how does it work? Imagine the price of a piece of cake you buy from your local bakery that changes from time to time. You noticed that the price for the cake stays within $5 to $6 on a regular basis. One day, the bakery decided to sell the cake at $3 a piece. Now that is cheap! But it also gets you thinking, why are they selling it so cheaply? Is it stale? Does it have less ingredients in it? If everything is the same as it was before, then it is truly cheap! This is the essence of how investors value the company by comparing it to its historical PE ratio.
Let's take an example below:
The example above (purple line) represents the historical PE ratio of Heineken Malaysia Berhad (HEIM). The highest PE ratio it ever achieved over the past 10 years was 33.34 whilst the lowest it achieved was 17.57 which gives an average PE ratio of 24.49. Therefore if I were to make a judgement based on HEIM’s PE ratio today of 28.66x, I would see that it is higher than the average and would be asking, why would I pay a higher than average PE Ratio for HEIM today? Is it because they are paying better dividends? Is it because they have captured more market share? If I cannot justify or find any reason why HEIM was better than it was previously to deserve a higher PE Ratio, then to me it is not worth paying the price. It’s a similar situation when the PE Ratio falls below average. I would be curious to why the market hated the stock to sell it at such a low PE ratio. If I find that the business’s fundamentals have not changed and that their earning potential remains the same or stronger, it is an opportunity to me.
2. Relative PE Ratio
Relative PE ratio simply means to compare the company to their peers within the industry which are carrying out similar businesses. For example, comparing Topglove Berhad to Hartalega Holdings Berhad. Both of them are in the glove manufacturing industry. Or perhaps to compare KPJ Healthcare Berhad to IHH Healthcare Berhad whereby both companies run and manage hospitals. This is different to part 1 whereby now we are comparing the price of a piece of cake from 2 different bakeries. If a chocolate cake in 1 bakery is more expensive than that in another bakery, we will be asking why is it more expensive? Are the ingredients better? Are the portions bigger? More expensive does not always mean that it is of better quality.
Now lets compare HEIM and another business with similar operations, Carlsberg Malaysia (Carlsberg). As we can see, the PE ratio of HEIM currently is 28.66x compared to Carlsberg of 35.36x. Carlsberg at this point is definitely more expensive compared to HEIM, but why?
If I compare the income generation capability of both companies side by side, I can see that the revenues and profits generated by both companies are similar.
But if I compare both companies from their balance sheet, I will see a different perspective:
I can see that HEIM’s total assets are 35% larger than Carlsberg. Therefore I can assume that HEIM would be stronger financially compared to Carlsberg. This way, I can then say that Carlsberg PE ratio of 35.66x makes it unreasonably more expensive compared to HEIM and would then be more inclined to invest in HEIM than Carlsberg. However, take note that you need to only compare it with companies with similar businesses. It is irrelevant to compare HEIM to Nestle for example.
3. Comparing PE ratio to growth potential
The 3rd way to evaluate the PE Ratio is to compare it the growth potential of the company. This basically applies to company which are currently experiencing very rapid growth. A fast growing company is basically a company which is able to grow their revenues by more than 15% every year. A fast growing company typically attracts a lot of attention from the investing community. The excitement creates huge demand for the share causing investors to bid up the share price which leads to a higher than usual PE Ratio. Therefore, we need to evaluate the growth rates of the company to determine if they are sustainable and justify the high PE Ratio. To justify the PE Ratio, it needs to be less than what I expect the growth rates to be in the future.
For example, Vitrox Corp Berhad at this point of writing, trades at a PE Ratio of 47.85x which is extremely high. But if I check their revenue growth rates over the past 10 years, I can see that they have been growing at an average CAGR of 31.3% per year. That means that even if they able to sustain that growth rate into the distant future, I would be willing to only buy the share when it trades at a maximum PE Ratio of 31x or below. But the key here is to also ensure that the growth rates are sustainable. If the company saw a spike in their revenues because of a one-off event, then It would not be qualified and using this method to evaluate them is extremely risky.
Using either one of this method of evaluating the PE Ratio of a stock can help investors make informed decisions and help them evaluate if a stock is cheap or expensive. The aim is always to buy a company below what it is truly worth. But please do remember that valuation should always be the last thing that the investor does. Evaluating the business to identify if they have a strong economic advantage and excellent management team must always be done first.
Disclaimer: All facts and opinions presented are for educational purposes only. This is not a recommendation to buy or to sell. The author involved in the writing of this message has no vested interest in the companies. Please consult a professional for expert financial or other assistance or legal advice.