Here is how I go about looking for value and analyzing stocks using the PE:
Understanding what goes into calculating a financial ratio will help with interrupting what the ratio number or percentage is actually saying. I encourage all investors from time to time get a company’s annual report and go through the Balance Sheet, P&L, and Cash Flow Statements and manually calculate a few ratios that you often use.
A commonly quoted ratio is the price to earnings ratio or PE. This ratio is calculated using the current share price of a stock and dividing this by the current earnings per share or EPS. The basic assumptions are that if a stock is trading on a high PE the stock is expensive and the market is expecting the stock to grow sales, earnings and profits. With the opposite said for stocks trading on low PE’s.
To understand this ratio better we need to break it down even further. First let’s look at the share price component of the ratio. The market is a forward-looking beast, and the current share price of most stocks already has a proportion of future growth priced in or the share price could be in the doldrums as the market view is that the future growth prospects of the company are very poor. A good example of this at the moment, is the PE ratios of most producing coal miners on the ASX. There is nothing wrong with the earnings profile of most coal stocks but for ESG reasons these companies are out of favor and there are potential regulatory and environmental issues that some investors are concerned about too. This poor market sentiment is driving down the share price of ASX listed coal miners and despite robust earnings they are trading on low PE’s as you are dividing a low share price with high EPS. For example, Whitehaven Coal (ASX:WHC) has a reported EPS CAGR of 42% over the last 6-years. Meaning they have grown EPS by 42% compounded over the last 6-years and are still only trading on a PE of 5.7, which is ridiculous!
The other component to the PE equation is EPS. This is after tax profit generated by the company. As such it is impacted by costs, depreciation & amortization, debt levels, and taxation. As we know manufactures generally have a higher cost…
