The price-earnings ratio, or PER (Price to Earnings Ratio) is a financial ratio that compares the price of a share with the earnings per share (EPS) of a company.
In other words, the PER ratio tells us how much investors are willing to pay for each euro of profit. Also known as P / E.
The PER is one of the most widely used financial ratios in fundamental analysis. It tells us if the stock of a company is overvalued or undervalued, because it tells us if the price of a share has risen or fallen a lot with respect to the profits of the company.
However, keep in mind that if a company's PER is very low (indicating price undervaluation) it may also mean that the company's shares are undervalued for good reason.
Interpretation of the PER
The PER can be interpreted as the number of years in which the company will take to generate the benefits equivalent to the price that the investor is paying for the share price. Since it is the number of times that the benefits are contained in the price. For example, if the price of a share is 15 euros and the profit per share per year is one euro (PER = 15), this indicates that in 15 years (if the profit remains stable) the company will generate enough profits to return the price initially paid.
A high PER, generally above 25, can indicate two things. On the one hand it can indicate that the company is overvalued, but on the other hand it can indicate that investors estimate that the company's profits will rise in the coming years. Therefore, it does not have to be bad, in fact, normally when a company has a high ratio it is said that it is a "growing company" and that its profits will rise over the next few years. Of course, it is very important to analyze what is the reason that the company has a high PER.
A small PER, below 15, indicates just the opposite. It may indicate that the company is undervalued or that investors think that the company's profits are going to fall.
The importance of the sectoral comparison
To know if the PER of a company is high or small, it is necessary to compare it with the rest of the companies in the sector. This is because there are sectors that by their nature tend to have smaller PERs, such as banks or service companies, since no large growth in profits is expected. However, there are other sectors that tend to have higher PERs, such as technology companies.
In short, in most cases, before reaching a conclusion, it is convenient to compare it with the rest of the sector. That is, with the PER of other companies that carry out a similar activity.
How PER is calculated
One of the reasons that has caused this price-earnings ratio to be so widely used is because of its ease of calculation and its simplicity to understand it. It is calculated by dividing the price of a share by the profit of the company per share:
PER = Price / EPS
It can also be calculated as:
PER = Market Capitalization / Net Profit
For example, if the PER of a company is 10, investors are paying 10 times what that company has earned in the year, that is, they are paying € 10 for each euro of profit. From another point of view, if we assume that a company is going to have the same benefits in the next few years, we could consider a PER 10 as the years it will take the company to earn what we have invested, in this case, it will take 10 years to recover the investment.
What is the average PER of a company?
Looking at the PER of a company alone does not make much sense, to use this ratio well we must compare it with that of its peers, that is, companies in the same industry with similar characteristics. For example, a PER of 17 for a bank may be high, but for a technology company it may be a low ratio.
One of the advantages of this financial ratio is that it is very easy to compare similar companies, in the national or international markets. The PER tells us at a stroke which company has better expectations. It can also be calculated even if the company does not pay dividends.
One of the drawbacks is that it uses data from different periods. It uses the current market price of the stock, while for profit it uses the latest data available, which may be from months ago. To address this issue, investors use the company's estimated EPS. Another drawback is that it is not useful for comparing companies that have a negative profit.