NBS doesn't care about PE ratios

The price to earnings ratio is calculated as follows...

A company generates a profit of $1 million, and has 500,000 shares issued; $2 of profit per share. 

The share price is trading at $50; to get the PE ratio we divide $50/2

Price to earnings of 25

 

How the PE ratio is used

It's very common to think that stocks on low PE ratios are cheap, compared to those trading on high PE's. 

You will commonly hear analysts and 'professionals' stating that a company is good value, as they are trading below their long term PE average values. Similarly, they will say a company is good value because their PE ratio is lower than that of their industries average PE. 

This doesn't matter to us. I'll explain simply. 

The PE ratio is simply a price tag. Nothing else. Companies on high PE's are regarded as better companies than those with low. Look at two companies in an industry. The market leader is on a PE of 30, whilst an inferior and uncompetitve, deteriorating company is on a PE of 5. 

Now textbooks and some professionals, will suggest that the company on the lower PE is better value than its competitor. This is quite clearly wrong. The high PE company has superior returns on capital invested, a greater competitive advantage, less debt etc. 

The low PE company is on a low PE because it's inferior, the market has given it a low value. 

All we need to know about the PE ratio is that it's the simplest of references to company value, in the eyes of the market. Companies on high PE's have quality investment attributes, companies on low PE's aren't valuable because of their low multiples; they are companies no-one values highly. 

Key takeaway

Don't pay any attention to changes in PE ratios as a primary reason for an investment decision. It's just a price tag that indicates that the market regards it as a good, or bad company.

 

You'll read articles on companies sustaining high PE's for so long, that this is the reason to sell out of them; this isn't necessarily true. Companies can & will trade on high PE multiples if the market likes them. 

On the same token, A LOW PE RATIO DOESN'T MEAN GOOD VALUE. 

I've made this mistake before. See my research piece on Shriro Holdings here....

NBSInvesting