A share’s price/earnings (PE) ratio is a key way of assessing whether it is trading at fair value and therefore if it is a good buy or not. This week, our expat financial services expert Brian Spence explains why PE ratios are so important in managing your investment portfolio.

It hardly needs to be said that your aim as an equities investor should be to buy low and sell high. Assessing whether a stock is trading at fair value based on its merits – or is over or under-valued – is a key part of making the right investment calls.

There are a variety of ways to try to work out if a particular stock represents good value or not and price-earnings ratio is foremost among these “vital statistics”.

In simple terms, a price-earnings ratio (or price multiple as it is sometimes known) shows how much an investor can expect to invest into a business in dollar terms in order to receive one dollar of that company’s earnings back. It is an invaluable metric for evaluating how attractive a company’s stock price is compared to the firm’s current earnings, and knowing how much investors are willing to pay per dollar of earnings is an important indicator of what its revenues are expected to be in future.

What is a good PE ratio?

The first thing to remember is that what constitutes a “normal” P/E ratio depends on the industry in question. For the S&P 500, the long-term average P/E is around 15x (meaning that the Index’s constituent companies are generally bought for 15 times more than their weighted average earnings). Generally, companies with subdued growth prospects or poor profit margins will trade at a lower P/E ratio and those where a higher growth rate is anticipated at a higher one.

Technology companies average around 20 since they tend to grow quickly and generate higher returns on equity, although PE ratios very much higher are also not unusual in this sector.

Netflix, for example, recently hit a PE ratio of 268, meaning that investors were willing to pay US$268 for every dollar the streaming giant was making. Netflix has already been the strongest-performing US stock this year. Its share price surged by 74 per cent in its first four months amid 7.4 million sign-ups in the first quarter. Such a huge PE ratio indicates that many investors feel the company is unstoppable. On the other hand, you could argue that this price is a classic example of technology hype and that the company is now hugely overvalued.

To make these numbers more meaningful, let’s strip it right back and imagine we had a business making something very tangible, like Vietnamese pho sold at the local market.

Imagine we charged $1 a bowl and sold 500 a week, making annual earnings in the region of $25,000. If we sold the business for $50,000 we would have a PE ratio of 2 (the price being twice the business’ earnings).

If, however, our humble pho business was valued on a PE earnings like that of Netflix, then we would sell it for $6.7 million. Unless you can be very, very optimistic of exponential sales growth for a very long period, such a valuation is clearly nonsensical. You’d need to sell a lot of pho to justify that price!

Determine true value

Viet Nam’s own market recently taught us, with the example of VTVCab, just how important fundamentals are in determining if a stock is good value or not. The cable channel firm recently had to cancel a planned Initial Public Offering since its P/E ratio had hit an incredible 334x – the highest ever in the Vietnamese market and a level that investors clearly didn’t feel was merited by its actual financial performance and prevailing business conditions.

This example, and those of Netflix and our pho business, neatly encapsulate the kinds of questions investors must ask themselves. Is this a stock with truly explosive growth potential, beyond what is already built into its price? Or, is this stock overvalued to a price way beyond that justified by its fundamentals?

Of course, there is a lot of fun to be had in picking individual winners, but the vagaries of the markets mean that many investors simply choose index or tracker funds so that their investment portfolio can benefit from general market rises instead. Or, you may prefer your portfolio to have a core holding of passive investments with room for stock-picking where you see potential to really win.

There are many different routes to investment success. If you would like to discuss the ways in which you can build a diversified portfolio which will help minimise your risks and maximise your gains, please get in touch.