The price-to-earnings ratio (also known as the P/E ratio) is one of the most valuable fundamental ratios. The P/E ratio is the key measure analysts use to determine a company's position relative to the rest of the market.
The P/E ratio divides a stock's share price by its earnings per share, equating a value that represents how much investors are willing to pay for each rand of a company's earnings.
The question is: why would we want to use a P/E ratio?
In short, as an investor we want quality companies at a decent price. Now the P/E ratio isn't the only way to determine the quality of a stock or company; however it is the most popular avenue.
Say we're using a P/E ratio to determine whether a stock is under or overvalued - the earnings per share element is an accounting number that will indicate the earnings of a particular share in the last 12 months.
The results of the equation will give you a multiple, this multiple will tell you how many years will it take you to get your return back based on the current market price.
Another way of putting it is that a stock with a lower P/E ratio costs less per share for the same level of financial performance than one with a higher P/E.
For example: assume the current market price for a company is R104.36 and the earnings per share is R7.889.
R104.36 is the price you will purchase the stock for (market value per share).
R7.889 is the earnings of a single share over the last 12 months (EPS).
In this calculation, the P/E equals 13.23, which means it will take you 13.23 years to make your money, in earnings, back based on the current market price.
So how does this affect the funds you are invested in?
Each asset manager will have its preferred method of how to gather data to incorporate into the P/E ratio to determine the value of a particular stock.
Allan Gray indicates that instead of using actual earnings, it prefers to assess the level of profitability and profit growth that appears sustainable over time. This is referred to as 'normalised' or 'trendline' earnings. This allows the company to separate out two factors in estimating a share's fundamental value: the estimate of future earnings, and the price Allan Gray would be prepared to pay for each rand of those earnings.
There are many factors to consider when investing, thus P/E ratios must be viewed within context such as what other investments are available and how interest rates play a part. For example, interest rates on cash are low and the prices of bonds and property funds are high. This may explain why current P/E ratios are also high.
This is why, as clients, we lack the full knowledge behind the intricacies of the market and must instead take advantage of the combined skill-set of our financial adviser and the asset manager to gain returns on investments.