Understanding PE ratios

By Andrew Palmer

3rd May 2007

P/E - "Price earnings ratio" is a funny number for humans because it is not linear so can be misleading if not understood, and future PE can be even more confusing.

Lets start with the basics, "P" is share price and "E" is the earnings per share.

P is easy to understand, but with "E" we need to ensure it is net income of the company for a 12 month period.

An example:

Company XYZ has a share price of $1 and earnings of $0.20

so we divide 1 by 0.2 and get a PE of 5, Put another way for every 5 dollars we invested the company should net 1$ in earnings

Take the same example with a share price of $1:

Earnings are $0.05 = PE = 20

Earnings are $0.1 = PE = 10

Earnings are $1 = PE = 1

Earnings are $2 = PE = 0.5 (Very Good company!)

A picture is a thousand words so below I have plotted a chart showing PE vs. percentage earnings per share. As can be seen they are related but not linear and as can be seen PE's in the low range like 1-4 are a very rough measure unless you go into a few decimal places as going from a PE of 2 to 1 is all the difference in the world:

Then when you bring future PE into the picture and try to work out a future share price one must consider the fair value of this type of share. In the general share market a fair value PE of 14 is normal (7.14% earnings per share)

So if you think the future PE of a company is good and the future PE you worked out is 3, and you put on a fair value PE of 14 then by definition the company will never actually have a PE of 3 but the share price will increase to a point where the PE is 14 and thus you have made your money from capital gain.

So again I have plotted this relationship using a fair value PE of 8 in this example, versus various possible future PE's:

Hypothetical example:

If we are assessing different silver mining companies in one area, and in this area silver companies normally traded at PE's of about 8, we may expect that the company being assessed should also trade for a PE of about 8. If we worked out or found data showing an expected future PE of 4 in 1 year then we would expect the share price to double within the next year. We can compare this to other companies and also to physical silver. If we thought silver would double to bring about the future PE of 4 then maybe we would just buy silver as the outcome would be the same. If the future PE was less than 4 then buying the stock may be the better option.

Now to take the next step I have potted below various fair value PE's against future PE's and % earnings per share. To read this as an example: A company we are looking at normally trades at a PE of 12 and we worked out a future PE of 1 then we might expect a share price increase of 1100% all going well, Nice!

So to calculate the future share price the inputs required are future PE and fair value PE.

So expected share price increase/decrease is:

Fair value PE

---------------- .. = Multiple of SP increase/ decrease

Future PE

For example:

Fair value of 8

--------------- .. = 2x SP gain or 100%

Future Value of 4

We can simply compare this to our expectations, or to another type of investment as a comparison.

Of course coming up with the future PE in the first place is an art in itself, but just understanding what it means is important as it is often referred to in stock assessment reports.