The acquisition price ratio (price-earnings ratio or P/E ratio), is an analytical tool used by investors to determine the feasibility of buying a stock. In essence, the P/E ratio tells you how much money you have to invest in order to earn every $1 of profit. A low P/E ratio is considered better because the investment cost per Rp1 of profit is less. At the same time, companies with high P/E ratios tend to have higher earnings growth in the future than companies with low P/E ratios. This article will provide a guide for calculating the P/E ratio and its use as a stock analysis tool.
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Part 1 of 2: Calculating the Ratio
Step 1. Learn the formula
The formula for calculating the P/E ratio is quite simple: market value per share divided by earnings per share (earnings per share or EPS). The form of the formula is the ratio P/E = (P/EPS), where P is the market price and EPS is earnings per share.
Step 2. Find market value information
The market value of a stock is very easy to know. Market value is the amount it costs to buy a stock from a publicly traded company on the Stock Exchange. For example, on November 4, 2015, the market price of Facebook's stock was Rp.103,940. The current market price of a stock can be found by searching for the stock symbol (usually four letters or less) or the company's full name followed by the word "share."
- The stock market price is always changing so that the P/E ratio also changes. When looking for the market price of a stock, just ignore the average, high or low price of the stock. The current market value is sufficient to find the P/E ratio.
- You should choose a specific price only if you are going to compare the P/E ratios of two different companies. In this case, the estimated market price used (eg the opening price on a particular day, or the exact current price) must be the same for both companies.
Step 3. Find the Earnings per Share value
Financial analysts generally use something called a trailing P/E ratio. In this case, EPS is calculated using the net income for the last four quarters (12 months), accounting for any stock splits, and then dividing by the number of shares outstanding on the market. However, analysts can also use a projected P/E ratio that uses forecasted earnings over the next four quarters.
- EPS values are usually available on financial websites in the stock reports section. You simply do a search on an internet search engine. If you want to calculate a company's EPS value yourself, the formula is as follows: (Net Profit – Dividend on Preferred Stock / Average Number of Common Stocks Outstanding). It should be noted that some sources use the number of shares traded at the end of the period (instead of the average number of shares outstanding during the period).
- Due to slightly different variations of the formula, different sources report different EPS values for the same company. However, these values are usually averaged to obtain an average EPS value.
Step 4. Calculate the cost ratio
Once the values for the two variables are obtained, all you have to do is plug them into the formula to calculate the P/E ratio. Let's use the example of a genuine public company. As of November 5, 2015, Yahoo! sells its shares at a price of Rp. 35,140.
- The first part of the P/E ratio formula has been obtained, namely the stock market price of Rp. 35,140.
- Next, we need to find the EPS value of Yahoo!. Just type “Yahoo!” and “EPS” in internet search engines if you don't want to calculate it yourself. On November 5, 2015, the EPS value of Yahoo! is Rp250 per share.
- Divide IDR 35,140 by IDR 250 and get the Yahoo! P/E ratio. around 141.
Part 2 of 2: Analyzing the Ratio
Step 1. Compare the P/E ratio with other companies in the same industry
The P/E ratio is useless on its own. This figure is meaningless if it is not compared to the P/E ratio of other companies in the same industry. Companies with low P/E ratios are considered “cheaper”. Investors can earn profits at low share prices. However, this analysis is not sufficient to determine the decision to buy shares of a company.
- For example, ABC stock sells for $15,000/share and its P/E ratio is 50. XYZ stock sells for $85,000 and its P/E ratio is 35. It's cheaper to buy XYZ stock, even though the price is higher. of ABC stock. This is because the investor pays Rp. 35 for Rp. 1 profit, while in ABC shares, the investor pays Rp. 50 for Rp. 1 profit.
- The P/E ratio is useless when compared to dissimilar firms. Each industry has a very different rate of valuation and growth. Therefore, the P/E ratio can only be compared if the companies measured are similar in size and type of industry.
Step 2. Recognize that the P/E ratio can be influenced by investors' expectations of the future value of the company
While it has often been considered an indicator of value in the past, the P/E ratio is also an indicator of investors' expectations for the future. This is because the stock price is a reflection of the mindset of investors on stock performance in the future. Therefore, a company with a high P/E ratio can mean that investors have high hopes for the company's growth in the future.
Conversely, a low P/E ratio indicates a company that is undervalued or has performed better today than in the past. In other words, the P/E ratio cannot be used as a single factor in determining the purchase decision of a company's stock
Step 3. Recognize that debt can reduce a company's P/E ratio
By increasing business loans, the company's risk will increase and reduce its P/E ratio. A lot of debt (high risk) will reduce the desire of investors to invest but debt usually increases the company's profit thereby increasing the P/E ratio. However, if the company's profits actually decrease, the portion of the return to shareholders is reduced because the company will prioritize returns to creditors first. However, in two companies with the same line of business, companies that have a fair amount of debt have a lower P/E ratio than companies without debt. Keep this in mind when using the P/E ratio as a company analysis tool.
