The price to earnings ratio (P/E) is one of the most widely used ratios for investors to determine the attractiveness of a stock. It is also very useful to assist investors in comparing the value of a stock to that of its peers or a benchmark, for instance the STOXX 600 index. The forward P/E ratio is an important constitute used by analysts in their valuation models, which calculates the value of a stock based on the forecasted earnings and a P/E multiple.
The P/E gives an indication if a stock is well priced or if there is an opportunity to either buy or sell a stock. If a company is trading at a high P/E as compared to its peers, it could mean that the stock is overvalued and possibly indicates a sell. Conversely, a low P/E could mean that the stock is undervalued and that a buy opportunity might exist.
Nonetheless, a high P/E does not automatically indicate that a stock is overvalued. As, it could otherwise mean that the market is anticipating future abnormal growth, which justifies the current high price of the stock. This particularly applies to growth companies, in comparison to mature companies which tend to have constant growth.
An essential component of the P/E ratio and any other comparable metric, is the presence of a large number of peers, which enable investors to compare the price of a particular stock to that of other stocks within the same sector.
Unfortunately, the local market is minuscule when compared to other indices, thus making it more difficult to find comparable stocks. Nevertheless, the below table analyses the P/E ratio of local equities whose market cap is above the €100 million level. The earnings per share (EPS) is based on the latest issued financials.
As can be analysed from the table above, local stocks have varying P/E multiples. This illustrates one of the main shortcomings of the P/E ratio when only a small number of peers are present.
The adjacent table compares the P/E of the local index to that of the other main European indices, which still has several short comings given the substantial differences between the two.
Nevertheless, it is interesting to note that all indices presented are trading at a P/E of around 17x or lower, except for the local index which is currently trading at 24.9x earnings. This proves that the stock variety of the local investor is limited, and consequently investors tend to push prices higher.
The price to earnings ratio is an important metric, nonetheless investors should not base their investment decision solely on the P/E as in certain cases a stock is trading at a particular P/E for other specific reasons. For instance, a particular company could be undergoing court proceedings, or the market is forecasting down grading earnings, which both would result in a lower P/E. In conclusion, the price to earnings ratio is useful tool in an investor toolbox, and should be used with other metrics to arrive at sound investment decisions.
This article was issued by Rowen Bonello, research analyst at Calamatta Cuschieri. For more information visit, https://cc.com.mt/ . The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.