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This one number holds the answers you need to know about a stock - you just need to know how to use it...

by , 18 February 2016

During the last Red Hot Penny Shares PowA! Hour Matthew asked me, “Francois, please explain the PE ratio, how important it is to a company and what an acceptable PE ratio is?”

The short answer to this question is the PE ratio shows you the relationship between the price of a share and the prof its the company is making.

But more impor tantly, the PE ratio tells you whether a share is cheap or expensive.

It could tell you where the share is going (and where the market thinks it is going). In fact, if you look at this ratio correctly you could see the stock's future, and what its price really should be…

Why the PE ratio is so important
 
The PE ratio tells you two of the most important things about a company. It shows the relationship between a company’s share price and its prof its hence its formula

PE =    Price    
          Earnings

That means it can give you an idea about the gains you can make based on the prof it growth of the company.
 
After all, the only reason to invest in a company is to make profits…
 
When company prof its go up share prices go up. When profits drop so do share prices.
 
Just have a look at this chart, it shows the JSE All Share Index as well as the ear nings per share – adjusted by the JSEs average PE.
 
On this chart you’ll see the trend of earnings growth compared to share prices.
 
There are periods where the one overshoots the other.
 
But they’re almost always followed by an upsurge or cor rection in share prices.
 
This chart is only for the period between 1995 and 2013. But it looks the same for longer periods. It also looks the same in different countries.

Whether you’re in South Africa, the USA or Japan in the long r un share prices track the prof its of companies.
 
How the PE ratio can help you invest
 
So now you know that a share’s price will go up if its ear nings keep going up.
 
That means there are a number of things you can use the PE ratio for to help you invest:
  • Let the PE ratio tell you if your share is a buy or not – Compare the PE ratio of a company to different companies in its sector. For instance, the technology sector has an average PE of 14.76, with shares Pinnacle Technology on a PE of 11, Business Connexion Group on a PE of 15 and EOH on a PE of 17. Which share would you rather own?

    Well, I’d like Pinnacle the most… This also helps answer Matthew’s question as to what PE is acceptable, in my opinion it would be the one that is at or below the industry average (but you need to consider possible growth for the share as well, which I’ll tell you about in a moment).
     
  • Let the PE ratio tell you what gains are possible for a share – You can calculate an estimated share price target using a share’s PE ratio.

    But you can arrive at a number of different answers if you use this formula. For instance you could use forecasted earnings per share (EPS) for the next year multiplied by the cur rent PE ratio. Or you could use the industry average PE ratio and current (or forecasted ear nings) to reach a target price. For instance, Onelogix is EPS is 22cps in 2012, if it grows earnings to 28cps in 2013 and continues to trade on a PE of 10 its target price is 280c. If it trades at a similar PE to Grindrod (15.36) its share price target would be 430c!

    But there are a few things you need to watch out for when using the PE ratio like this. If you don’t it will lead to bad results
What to watch out for when using the PE ratio

The PE ratio is very useful, and can tell you some very important information about a share. But only if you use it in the right way and watch out for a number of pitfalls:
 
PE Pitfall #1 – Company prof its change every day, but the market only gets news on them twice a year (and in some cases quarterly). That means the PE ratio you see for a company might not be very accurate.
 
PE Pitfall #2 – The PE doesn’t tell you anything about future g rowth of a company. That’s why you need to use forecasts for future prof its, like I told you above. Getting hold of reliable forecasts for many of the penny shares isn’t easy if you’re a retail investor unless you’re willing to do hard work yourself. If you don’t – that’s what Red Hot Penny Shares is for!
 
PE Pitfall #3 – Life happens. No matter what your forecasts are or how accurate you predict share price movement there’s no way to know about outliers like strikes, floods or fires that could lead to a company’s prof its crumbling.
 
PE Pitfall #4 – Many investors look ONLY at the PE ratio as a be all and end all. DON’T. Company’s debt, inventory and management changes can seriously affect prof its as well. If you look at the PE blindly without anything else to guide you you could be in for a g reat surprise…
 
Always keep these four PE Pitfalls in mind when using the PE ratio for investing. The PE is a powerful tool that can help you a lot. But only when used cor rectly…


This one number holds the answers you need to know about a stock - you just need to know how to use it...
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