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Interpreting the Price/Earnings Ratio
[Part 1: Interpreting the Price/Earnings Ratio - Why Connect Price to Earnings?]
by Jenny Luesby
 More of this Feature
• Part 1: Interpreting the Price/Earnings Ratio - Why Connect Price to Earnings?
• Part 2: Interpreting the Price/Earnings Ratio - Could it be Irrational Exuberance?
 Related Resources
• Glossary of Economics Terms

People who own shares want to know one thing above all - which way is the share price headed? Without reaching for the crystal ball, there is a financial ratio that can give us some clues on whether shares are cheap or expensive.

Most business journalists fight shy of this ratio, and so do the majority of investors. It's hard to understand why. The p/e ratios is simple to calculate and probably the most consistent red flag to excessive optimism and over-investment. It also serves, regularly, as a marker of business problems and opportunities. So, if you can bear to divide one number by another and interpret the results, our advice is: it's worth the effort!

Calculating the Ratio

The starting point for the P/E ratio is the share price. This is the P.

The P/E takes this share price and divides it by earnings per share (which is the company's entire net profit, or earnings, divided by the number of shares in issue). This is the E.

Together these two numbers relate the market's valuation of a company's shares to the wealth the company is actually creating.

Why connect price to earnings?

Any share price is built on expectations of a company's future performance. Some of these expectations will be based on fundamentals - such as the company's recent performance, its new product lines, and the prospects for its sector. The rest will reflect prevailing moods, fashions and sentiment.

By relating share prices to actual profits, the P/E ratio highlights the connection between the price and recent company performance. If prices get higher and profits get higher, the ratio stays the same. The ratio only moves as price and profits become disconnected.

For this reason, when the ratio is higher or lower than normal we know that recent profit levels are no longer the main factor in pricing. This might be because change is afoot - investors expect a much better or worse performance next year - or because sentiment is now the dominant factor. Either situation is news worthy.

How it works in practice

In the summer of 2001, the average P/E ratio across all shares listed on the London Stock Exchange was running at around 21. Yet the average P/E for Telecom was 67. Immediately we can see that share prices are far higher for Telecom companies, compared to profit levels, than they are for companies generally.

If we look for fundamental reasons for this, we can see that the sector has been hard hit recently by licence costs and the global economic slowdown. So current profits may be unusually low. Investors obviously "feel" certain of a better performance in future. Indeed, a P/E of 67 suggests expectations of huge forthcoming profit hikes. But how justified is this? And are we now looking at shares that are appropriately valued on the basis of future profit expectations alone?

Testing for future profits

Generally, we test for the importance of future profits to the current P/E by building a prospective P/E ratio. This takes the current share price (P) and divides it by forecast earnings per share (E) for next year, and even the following year. We get these earnings forecasts from stockbrokers' analysts.

If next year's profits are on course to be significantly higher than this year's, the prospective P/E ratio will be lower than the current P/E ratio. For companies and sectors in take-off or rapid growth this often turns out to be the case. The abnormally high current P/E ratio simply reflects future profit levels - they have already been written in to the share price.

However, in the case of telecom, shares still look over-valued when we take into account forecasts for future growth and profits.

Next page > Part 2: Interpreting the Price/Earnings Ratio - Could it be Irrational Exuberance? > Page 1, 2.

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