P/E (Price/Earnings)

Learn to Invest – Quantified Investment Course Quantified Investment Strategies P/E (Price/Earnings)

The price/earnings ratio of a company is the share price compared to the company’s earnings per share.

The ratio is used for valuing companies and finding out whether they are undervalued or overvalued. P/E is, therefore, what you pay to purchase a share of the company’s profit. If the price of the share is 90 and earnings per share is 10, then P/E is equal to 9.

A high P/E means that you’re paying a lot for the profit. On the other hand, a low P/E means that you are paying little on the profit.

While there are many reasons why companies are traded at different P / E, the main reason is usually the market’s belief (or lack of faith) in the company’s future.

If earnings are declining or little growth is expected in the future, there is a plausible reason to give the share a lower P / E than if much growth is expected.

It is natural for earnings per share to vary from year to year, but you should see a positive trend over a period of 5-10 years.

If the company has historically increased earnings per share by 5% per year, it may be natural to assume that earnings per share will grow by 5% also in the future. The following figure shows the development in earnings per share (EPS) and free cash flow per share for Swedish Match, a Swedish “sin-stock”:

In the above figure, Swedish Match shows a relatively steady and nice increase in earnings per share along with a steady and rising trend in EPS with a CAGR of 7%.

This is what you want when you invest: a steady trend that indicates that the company has stable earnings, which also makes it easier to estimate future earnings.

It is thoroughly documented that low P / E gives better returns than high P / E. David Dreman’s Contrarian Investment Strategies (published 1996) was one of the first books to deal only with what is called value investing. Dreman divided the shares into five quintiles rated P / E:

The investment firm Alpha Architect conducted a survey on P / E based on a universe of stocks consisting of mid-cap and large-cap stocks from 1964 to 2015. The returns looked like this when separated into different groups based on the P/E levels: