Still confused about P/E ratio

S

Skin

Guest
I spent some time learning about P/E ratios. This is the Price to Earnings ratio and discovered that "earnings" means after-tax profit.

The confusion sets in when I look at certain irish banks in todays stock market that are trading with a P/E ratio of less than 8.

So if I were to invest in one share of these banks I would effectively be getting a share that returns a profit of over 12.5% in one year for that share.

Is this not a bargain?? If so why is the price so low?? Or what am I misunderstanding??
 
Theoretically yes, A P/E ratio represents the profit as a factor of the price you pay for the shares and in a perfect world should be reflected in a combination of the dividend paid and an increase in the share price. But it's not a perfect world and the "prospective" P/E ratio which is a guess at what future results will be like is more commonly used. In the case of banks I would think the current share price may reflect prospective P/E s at a higher number due to the current turmoil.
 
Skin said:
Or what am I misunderstanding??
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The fact that expectations/assumptions about future earnings may be wrong? There are companies with P/E ratios in the 100s (I work for one with a P/E of about 30!) but it doesn't mean that these are a bargain. P/E is not the same as CAR for example. Looking at P/E alone when choosing stocks doesn't make sense.
 
Thanks guys, but am still a bit confused. Let me go on with an example.

Company Z trades at €16.00 per share. Earnings were €1.40 for the previous financial year, giving a P/E ratio of 11.42.
During the year the company annouces a profit warning due to unseasonal factors or whatever... and the share price tumbles to €10.00. The P/E ratio now stands at 7.14 on foot of lower expected earnings. And true enough earnings the following year come in at €1.00, which in turn gives a new P/E ratio of 10. Which says to me if I had bought one share in this company at €10.00 it still would have generated a return of 10% - is this still not a bargain or am i completey on the wrong track??
 
But the P/E ratio at any point in time does not guarantee what the future returns will be! Earnings the following year could be €1 per share or something else altogether.
 
True, but if the share price falls 37.5%, as in my example then the earnings per share need to fall by a greater per centage than that before you are losing value.

Example, if i spent E16,000 buying at 16.00 i get 1,000 earning 1.40 per share.

However if i didnt buy at that price but bought at 10.00 i would have ended up with 1600 generating a return of 1.00 per share.

So what I am saying is that certain banks on the ISEQ have fallen by 25%+ in recent times, yet has there been any indicator that the banks earnings are forecasted to drop by so much?? I dont think so, maybe I'm naive but I think there are bargains galore out there.
 
I think you are confusing earnings per share with what you as a shareholder actually receive - e.g. in dividends or capital gains. You cannot assume that because the company earns x% that this return will be directly reflected in terms of capital gains or dividend income!
 
Thanks

But I'm not confusing the earnings with the dividends or the capital gains.

What I am saying is that if you invest €1.00 in a share that say returns a profit of €0.10 for the year that is a 10% return, or a P/E of 10.

If the share price falls by 50% to €0.50 on foot of a gloomy economic forecast then what I am saying is that the EPS for that stock has to fall by 50% before you are losing value (obviously until the accounts are done its anyones guess as to what that will be, but companies on the stock market do give indications and make forecasts).
If in turn the EPS fell to €0.07 (as a result of a slowdown in the economy) this still represents value for money if you buy the share at €0.50.

My point is that a lot of companies have seen their share nose dive recently, as a result I would have expected to hear more noise about profit warnings etc - I havent, have you?
So I am figuring that the stock market is a kin to a bargain basement at the moment particularly in the banking sector.
 
Skin said:
a share that say returns a profit of €0.10 for the year
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What precisely do you mean by this? Company profits (not necessarily paid out to shareholders or reflected in share price in part or full)? Dividends? Capital appreciation? Something else? You still seem to be confusing P/E ratios with guaranteed returns, interest rates or something like that.
 
Skin said:
Thanks

What I am saying is that if you invest €1.00 in a share that say returns a profit of €0.10 for the year that is a 10% return, or a P/E of 10.


My point is that a lot of companies have seen their share nose dive recently, as a result I would have expected to hear more noise about profit warnings etc - I havent, have you?
So I am figuring that the stock market is a kin to a bargain basement at the moment particularly in the banking sector.
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I don't know what you mean either do be honest. Are you talking about dividend yield or soemething?

Also as for Irish banks, there may not be profit warnings but Davy stockbrokers have lowered future growth and earnings and reduced target share price.
 
Skin said:
So what I am saying is that certain banks on the ISEQ have fallen by 25%+ in recent times, yet has there been any indicator that the banks earnings are forecasted to drop by so much?? I dont think so, maybe I'm naive but I think there are bargains galore out there.
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The P/E ratio is a very simplistic tool for analysis. To analyse the expectations implied by share prices you need to understand discounted cash flow: http://en.wikipedia.org/wiki/Discounted_cash_flow
 
Sunny said:
I don't know what you mean either do be honest. Are you talking about dividend yield or soemething?

Also as for Irish banks, there may not be profit warnings but Davy stockbrokers have lowered future growth and earnings and reduced target share price.
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Ok, I'm confusing others now!!

But the comment above is along the lines of what I mean, you say "Davy stockbrokers have lowered future growth and earnings".
But by how much? -25%?? (25% being the fall in the share price).
If growth and earnings are "lowered" from 5% to 4% then surely the share price represents good value after falling 25%?

If this is wrong someone please explain how, thanks.
 
This might be a waste of time but here goes anyway!

The NPV formula is: r = E/P + g [or P = E/(r-g)], where r = required rate of return, E = EPS, P = share price and g = expected long-term growth rate.

Suppose share X has E = 1 and g = 6%, and the rate of return investors require is 10%, then P = 1/(.1-.06) = 25.

Now suppose that expectations for this company change slightly so that E = 0.95 and g = 5.5% and also the risk premium required by investors increases slightly so r = 10.5%. In this case P = .95/(.105-.055) = 19. So even a 5% decrease in EPS expected for the year can easily result in a large fall in the share price in certain circumstances, in this case 24%.
 
zephyro said:
This might be a waste of time but here goes anyway!

The NPV formula is: r = E/P + g [or P = E/(r-g)], where r = required rate of return, E = EPS, P = share price and g = expected long-term growth rate.

Suppose share X has E = 1 and g = 6%, and the rate of return investors require is 10%, then P = 1/(.1-.06) = 25.

Now suppose that expectations for this company change slightly so that E = 0.95 and g = 5.5% and also the risk premium required by investors increases slightly so r = 10.5%. In this case P = .95/(.105-.055) = 19. So even a 5% decrease in EPS expected for the year can easily result in a large fall in the share price in certain circumstances, in this case 24%.
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Thank you very much.

This illustrates to me how the share price can be affected by economic forecasts and beyond any P/E ratio. I am grateful for your contribution.

However it opens up another question. You state the "rate of return investors require"...this seems a bit vague to me. Who, or how, is the "rate of return investors require" determind?
 
Skin said:
You state the "rate of return investors require"...this seems a bit vague to me.
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That's because it is a bit vague! Or at least not easy to measure. It is generally expressed as a premium over the risk-free rate, i.e. if the "riskless" rate of interest on government bonds is 8% and the required additional risk premium for equity investors is 2% then it would be 10%. The value of the equity risk premium depends on the risk perceptions of equity investors on average.
 
Basically, your confusion is over the earnings.

You, as a shareholder ,don’t receive all the company’s earning. The company uses its earnings to pay off debt, finance ongoing projects and invest in new ones. Companies also retain earnings. If there is any left over, it is distributed as dividends to shareholders: so you only get the dividends, not the earnings. So you should also look at a company’s dividend yield, as well as its P/E ratio.

Skin said:
The confusion sets in when I look at certain irish banks in todays stock market that are trading with a P/E ratio of less than 8.
So if I were to invest in one share of these banks I would effectively be getting a share that returns a profit of over 12.5% in one year for that share.
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The answer is no. You would buy shares with the expectation that for every €8 you invest the bank would earn €1 with it, i.e. it should take about 8 years for the bank to earn enough to cover your investment.
It does not mean your share (or your share plus dividends) would increase in value by 12.5%.
 
Thanks

But I dont have an misunderstanding of earnings and dividends. I know that the company may not pay out any dividend even if it earns a profit. But the money has to go somewhere, either re-invested or as you say, paying off debt. On all counts it is good for the company, therefore good for the shareholder.

Where I was getting confused was how such projected earnings, even if they were to be lowered, could have such a negative effect of the share price e.g. the forecast for company Z has lowered expected earnings from a 5% increase to 4%. I was wondering how such a statement could reduce a share price by 25% without representing good value.
Zephyro has illustrated that for me in the above post.
 
Skin your original question was are the Irish bank's bargains. The NPV formula doesn't really explain the recent decline in the price of the major banks.

Neither AIB or Bank of Ireland have reduced their earning forecasts or their growth rate in fact AIB recently increased their's from low teens to mid teens. You could argue the rate of return investors require has increased due to recent market turbulence.

The real reason for the fall is that investors are worried about the state of the housing market, interest rates and it's potential for default and bad debt. Most foreign investors are getting out of Irish stocks based on these fears. They are also worried about any nasty surprises the sub prime issue may bring.

Whether or not the Irish banks are a good investments or not depends on whether you believe this fear and the level of the price falls are justified or not.
 
i think you also need to have a look at p/e ratios in the sector in other companies, as well as in the same sector in other countries, a p/e ratio for a company does not mean much on its own. it a bit like saying a price is expensive or cheap for a good/service if you have no alternatives.
 
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