How to interpret the P/E ratio
The long-term trend for the P/E ratio of the Australian market is around 15, although it has bounced about a bit in recent years.
You can use a P/E ratio to compare a company’s cost to that of the broader market or against its peers in the same sector.
If, for example, you had one company trading with a P/E ratio of 10 and another with a P/E of 20, you’d say that the lower P/E indicated a cheaper stock. This is because you are paying less (half as much, in fact) for each dollar of the company’s earnings.
It doesn’t end there, however, as a P/E ratio viewed in isolation won’t tell an investor everything they need to know.
Investors are concerned less with a company’s past earnings, than with its future earnings potential.
So, while a company’s P/E ratio might be 20 now and seem expensive given it would take a long time to earn back the money invested, if a company’s profit grows from year to year, then all of a sudden the payback timeline gets shorter and it looks a lot less expensive.
By the same token, just because a company looks relatively cheap on a P/E basis, that doesn’t mean it’s good value. Profit could stay the same from year to year, meaning it will take a very long time to make a return on investment, or profits could actually go backwards meaning you never make the return you want in the timeframe you have.
Another thing to remember is that profit numbers can sometimes be distorted by one-off earnings or losses meaning that figure doesn’t represent the ongoing, or ‘operating’ profit, which is the earnings generated from a company’s core business.