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If connecting to the Internet is not your cup of tea, then another more widely available option is checking your shares through the newspaper. Most Australian newspapers will print the previous days, end of day stock market prices, as well as providing some simple commentary on the movements within the market. The newspaper presents this information in a format that may be unusual if you have never looked in the section before, but after reading this tutorial you hopefully have a better understanding of how it all works!
The majority of these headings are self explanatory except the PE Ratio heading which deserves further discussion. Before reading the following explanation it would be useful to read through the Stock Basics tutorial, in order to gain a fundamental understanding of how the Stock Market Operates.
The PE Ratio is one of the oldest and most frequently used share price indicators, and this is why it is published in most newspapers. The PE Ratio is a calculated ratio of a company’s share price in relation to its earnings-per-share for a whole year. It is useful to know that the average PE Ratio is around 15 to 25, which may not mean all that much yet!
While the calculation of the PE Ratio is a simple one:
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The actual basis and reasoning behind why, and how it is calculated is quite complex. The underlying fact you must be aware of when using the standard PE Ratio, is that you are relying on data that is historical. This implies that you analyzing historical data, in order to predict future share price movements, and this always adds an element of risk before even looking at ratio.
However, basically the PE Ratio reveals how much investors are prepared to pay, per dollar, in relation to company earnings. In its simplest form, this means that a PE Ratio of 25 implies that you will be willing to pay $25 dollars for every $1 dollar that the company earns. This is the meaning of the ratio in its most simplistic form, and there are many other factors that must be considered before truly understanding the purpose of the ratio.
For the PE Ratio to be effective, it must take into account both a company’s growth rate, and can only be used to compare companies within the same industry segment. The reasoning behind these two points is explained below:
Company Growth Rate
A company can only grow so fast, and so far, until it reaches a point where investors believe that it cannot grow any further. This occurs because investor emotion is the main driver behind volatility in share market which consequently makes it so unpredictable. The PE Ratio is also affected by this notion.
While the ratio can be getting larger and larger, implying investors are willing to pay more and more for every dollar of company earnings – there is an underlying rationale that this type of growth cannot be sustained, and must eventually reach a point where it will flatten out or decline. The reasoning behind this is correlated to the fact that as the PE Ratio increases, the market is expecting more and more from the company which implies it has to continually produce higher and higher returns. If it does not, its share price will begin to falter, and it is at this point that a reduction in the PE Ratio occurs. Usually companies that have sustained such high growth periods will solidify their positions and ensure that their operating income will continue to prosper into the future. This means that their PE Ratio remains above the market average and still draws investor interest.
Industry Segment
The reasoning behind comparing industry segments, still revolves around this notion of volatility, and realizing that each industry has highly different volatilities factors specific to that industry. For example – typically the food and retail industry remains consistent and produces stable growth rates with medium returns. Contrast this against the technology sector which fluctuates between periods of highly-elevated growth rates, and unstable returns. Attempting to drawing comparisons against these two industries using the PE Ratio would be fruitless because there volatility factors are so different.
So when you begin using the PE Ratio, it is important realize there a number of elements involved. Firstly, a $5 dollar stock with a PE Ratio of 100 is considered a lot more costly than a stock with a price of $200 dollars and a PE Ratio of 10. This is because you cannot just compare too different stocks without taking into account the above mentioned factors. The main problems to be aware of when using the ratio stem from its underpinnings and market movement. The denominator of the ratio is Earnings Per Share and it is important to find out how this figure was derived because it can distort the overall ratio if it calculated incorrectly. For example, if the Last Sale Price was at $5 dollars and the Earnings Per Share was calculated at $0.10 cents then this would mean that PE Ratio is at 50, however if this figure was calculated incorrectly and the true Earnings per Share should have been $0.20, then the real PE Ratio is only 25. It is this sort of distortion that many companies can achieve by altering how exactly Earnings Per Share is calculated and while this will not be explored in this tutorial – it is important to be aware of.
The other main problem with the PE Ratio stems from inflation and its effect on the ratio. If there is low inflation then typically the PE Ratio rises because a company’s earnings are not adversely effected by inflation, which means that the ratio gives a fairly good indication of a company’s performance. Conversely, if inflation is high then the ratio usually lowers to reflect the higher earnings generated by this fact. Therefore, the PE Ratio can consistently fluctuate during periods of volatile inflation, making it important to look at the PE Ratio over a period of time, in order to develop a trend of its movements if inflation is constantly changing.