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Price & Quality


PRICE EARNING RATIO (PER)
PE=MARKET PRICE/EPS

This is not an academic blog, however I would like to write about the Price Earning Ratio or PE ratio. This ratio is very used in the industry and you would find very easily in the economic news papers.
 It can be calculated by dividing the market value of the stock by the earning per share (EPS) or dividing the total market capitalization by the total earning. A high ratio indicates that investors have a positive perception of the company (the investors are discounting high growth of a company).


As lower the PE ratio, cheaper will be the stock in particular. Value investors try to find good companies with low PE ratio (we assume that the market is inefficient or weak efficient), otherwise the investor would not invest in a company wih a low PE ratio. Comparing PE ratios of different companies is meaningless, companies ratios has to be compared inside their industry. We also can not consider this ratio in insolation when it comes to take an investment decision. My personal opinion is that we not only should consider the price but also the quality of the company, how much is it going to growth?. In companies with high growth expectation is normal to have high PE ratio (Inditex or Google are two very good examples). While the company has the ability to find  new projects with positive NPV (Net present Value), always it is worthy to consider these companies even they have a high ratio. 

The mean PE ratio for the S&P 500 (this is the index of the 500 biggest companies in USA) is around 16 and currently it has a PE ratio of 25. For that reason many equity analyst consider that the american market is expensive. But as you know the statistic does mean much sometimes.




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