PER

Hi Karen,

I hope the following helps:

Definition P/E Ratio = MPS / EPS

This means, P/E ratios are calculated from the current market value of the shares and the most recent year’s earnings per share (EPS).

The share price reflects the investors assessment or confidence in the business’s future performance.

The EPS reflects historical data.

Let me know if high PER is good or bad?

Assessing P/E’s is a matter of ANALYSIS , JUDGEMENT and opinion. The context has to be like with like (comparisons within the same industry or same company over time or forecast versus actual, etc).

As a ratio, it is clearly open to ANYTHING which influences a company’s current share price on the one hand and ANYTHING which has influenced the most recent after tax profit figure in the historical accounts, on the other.

As a generalization, businesses that have a high share price relative to their recent historic earnings have high PER’s. This may be because their future is regarded as economically bright, which may be the result of investing heavily in the future at the expense of recent profits (earnings). In this case a high PER should be regarded as good.

On the other hand, high P/E’s also arise where businesses have recent low earnings but investors believe their future is brighter.

A company may experience a sharp and dramatic downturn in business and EPS. But, if the corresponding fall in the share price is not nearly as bad or as steep as the dramatic fall in EPS (think of the EMH here) then the P/E ratio will appear to have improved dramatically! In this case, the high PER is clearly bad. (Of course in the exam, I would always QUALIFY my answer here).

The recent banking crisis, the liquidity crisis and the partial collapse in the stock markets has meant that many company P/E’s have been unusually low lately.

It should be remembered that share prices can change at alarming speed, and so it stands to reason that the P/E ratio also can change at alarming speed. Look at trends and underlying reasons for changes in the components of the P/E ratio.

Just thinking about the numerator for a second: the price of a share (or the price of a forex rate, or any commodity for that matter) is determined by the forces of SUPPLY and DEMAND.

Thus anything which influences either of these forces will affect the share price, which in turn ultimately affects the P/E ratio.

For example, Company Announcements (EMH, NPV decisions, Rights Issues, etc) or other company specific factors such as the Industry, Dividend Valuation Models, Dividend Yields, Earnings Yields, Dividend Policy, Profitability, Liquidity, ROCE, TSR, EPS, Gearing / Capital Structure, Working Capital Management, etc., have a degree of influence on the share price.

More general macro factors might include Government Monetary Policy, Fiscal Policy, Term Structure of Interest Rates (the Interest Yield Curve), Interest Rates abroad, Inflation or uncertainty about future inflation, Hot Money (investments with higher rates of return implies increased demand for money which affects the flow of money (supply/demand) in and out of the major Financial Centers), Speculators (can be a very powerful force), Confidence (either in the Government, the Company in question, the Economy), Political Factors (a country’s political and economic stability Ireland, Italy, Greece, Iceland), Sentiment (in either the government or the economy or the particular company), etc., etc.,

Now think for awhile about the determinants of a company’s EPS…. and then put the two sets of data together and see if it doesn’t help you make more sense of the P/E ratio itself.

Regards, Kevin Kelly

Thanks, does this mean that in itself it is not an indicator - it needs to be looked at together with the components that make it eg: EPS, Share Price to establish why there is a change, then perhaps look wider at the market in general (other companies in the same sector to establish if they too have changed at the same pace?)

Hi Karen,
It is an indicator, but like all indicators it needs to be interpreted within the context of the industry within which the company belongs, within the context of other ratios (indicators), other relevant information, trends over time, etc., etc.,

A full and satisfactory conclusion is reached when all relevant information has been considered.

Regards, Kevin Kelly

Ok thanks :)