The PER ratio (Price Earning Ratio) is probably the ratio most used by the investment community. It is obtained by relating the capitalization of a company to its profits or, what is the same, its price divided by earnings per share (EPS).
If a company is listed at 100 euros and its EPS is 5 euros, its PER would be 20 times (100/5). In other words, at constant profits, we would need 20 years to recover the investment.
If a PER is high, it means that the market is willing to pay more for the company’s future flows.. On the opposite side, a lower P/E ratio indicates that the market is not very confident in the stock’s future and will pay less for expected flows.
Following the PER, we can arrive at the profitability of the benefits, that is, the inverse of the PER. In this case, 1/20 = 0.05… The profitability of the company’s profits is 5%.
As we can see, given the simplicity of this ratio, it has been very popular and, probably, it is one of the first metrics that stock investors learn. However, using it in isolation is a serious mistake.
The problem of using the PER
The first problem that we find with the PER is that it only looks at the benefits of the companywhich means ignoring how the company’s balance sheet is structured, especially the debt.
Let’s think that market capitalization only represents the shareholder’s contribution to the company’s capital, which means that it does not include any debt or cash on the balance sheet. Companies with large debt issues are obviously higher risk investments, and this is not taken into account in the PER. We can face a low PER and that in the current year the company goes bankrupt.
On the other hand, let us remember that profit is an accounting result that can be shaped with provisions and amortizations among other accounting adjustments. Many publicly traded companies are reporting profits but not generating cash. Hence, the importance of keeping an eye on the Statement of Cash Flows, specifically the cash flow generated by operating activities.
Another problem that we face is that a PER of 10 times is better than a PER of 20 times: the company is cheaper. And it is that It is based on the premise that this certain company will obtain its current benefits during the next 10 years and that an investor will recover the investment.
A company’s profits may well rise or fall significantly in the next 10 years. In fact, some stocks have been trading at low PERs for many years, as is the case with European bank stocks… A value trap is produced by the decline of a sector.
As investors we must have a greater predisposition for sectors whose profits are going to increase significantly over the next 10 years instead of decreasing significantly… Obviously, as the PER is formed, there is no way to discriminate these companies.
A low PER may be the result of an exaggeration on the part of the market… There we would be before an opportunity, but before reaching that conclusion we must thoroughly examine if there are structural problems in the company, if it is in a dying industry, it loads too many debts or losing market share to competitors.
Nor does a high PER, in isolation, reveal great information.. For example, when the stock market tanked in 2008 until the first quarter of 2009, the P/E skyrocketed. And it is that corporate profits plummeted: The PER showed a reading of 123.73 times in May 2009.
For those investors who focused on the P/E ratio, an opportunity passed them by of entry to incorporate large stocks into the portfolio at low prices.