A company’s price-to-earnings ratio (P/E) is a useful performance measurement. But it may not be enough, particularly in difficult and volatile trading conditions.
Equally, should you apply the same valuation measures to every company in your portfolio, or is it necessary to make exceptions depending on the characteristics of a given company?
Before we can understand the concept of relative value, we must first be clear about what we mean by the simple equity market capitalisation value.
Assume that a public-listed company has 300,000,000 shares in issue, trading at a price of 500p. In this case, the simple market capitalisation value is £1.5bn.
300,000,000 x £5 = £1.5bn.
P/E is probably the most popular relative valuation metric in use. Taking the same example of the company above, with a £1.5bn stock market valuation, how do we find out the P/E? The answer is that it all depends on how much profit the company makes.
So, if we imagine the £1.5bn company has annual net profits of £200m, its P/E ratio would be:
£1,500,000,000/£200,000,000 = 7.5
The company in our example has a P/E ratio of 7.5, or as commonly stated 7.5 times – it is valued at 7.5 times its earnings.
As the term would imply, relative value measures are just that; to have any real meaning, such ratios need to be compared with a reference point such as a peer group average.
For instance, the company in our example could appear cheap if the average company in its sector is valued at 10 times.
One problem with P/E though is what can happen when the going gets tough for the companies in our portfolios. Even good-quality companies can experience short-term periods when earnings turn negative. When this happens, P/E can cease to become a useful measure, providing invalid results.
In these cases, analysts must resort to other ratios that can still provide meaningful results even in difficult times. One such popular alternative measure is P/S, or price to sales.
If the £1.5bn company has annual sales of £375m per annum, its P/S ratio would be:
£1,500,000,000/£375,000,000 = 4
As commonly stated, the company in this example is valued at four times its sales. For instance, the company could appear cheap if companies in its sector are valued at five times sales on average.
While this gets around the problem of valuing companies that are reporting losses at difficult times, it also lends itself well to valuing companies that have not yet achieved profitability because they are in their early stages of development.
Earnings depend on accountants
Another problem with the P/E ratio is that the denominator of the equation, earnings, is subject to many elements of management discretion. These might include:
- Amortisation (the process of repaying debt through scheduled payments)
- Depreciation (allocating the cost of tangible assets over their useful life)
In short, P/E should not be relied on in isolation, but rather should be used in conjunction with other measures.