Valuation is an act of quantifying the fair value of a company. In this article, it’s all about company valuation. There is no magical way to quantify the value. First and foremost, there are just Comparative Methods and Discounted Cash Flow method. The former is the golden standard. Given the imperfection of valuation, these method are useful to rely on. This methods help you to triangulate around reality.
What is PE ratio?
Price to Earning,PE ratio is a part of Fundamental Analysis which uses Comparative Methods. Specifically Multiple Method. It uses Price,P of a share price then divided by its Earning per Share, EPS. Is a metric to express how much investors are paying for every RM 1 of company earnings. Basically your willingness to pay certain amount of money in order to earn a return from your purchase. Actually we’ve been using this method in our daily lives. Particularly when it involves Personal Finance.
For instance, whenever you wanted to buy a house, we tend to compare price of the house to its area. Let says, price per square foot, sqft for location A is RM 300 per sqft. While in location B is RM 500 per sqft. If this comparison is well equitable in all aspect, therefor house in location B is a bargain to buy.
How to use PE ratio?
PE ratio provide a standardised way to analyze stocks that have different prices and earnings levels. They are used to:
- Use for valuation
- A higher PE ratio means a stock is more expensive relative to its earnings. Lower PE ratio means a stock is less expensive relative to its earnings. Stocks or mutual funds having a high PE ratio are usually classified as growth investments. Those having lower PE ratio is usually classified as value investments.
- Compare stocks
- The PE ratio can be used to differentiate one stock against that of other stocks within the same industry. Or against the PE ratios of stocks within the broader market. As such as those comprising the FTSE Bursa Malaysia Emas Index or FTSE Bursa Malaysia KLCI Index.
- Predict future returns
- Companies that grow extremely quickly such as technology companies have higher P/E ratios because investors are willing to pay a higher share price now on the expectation of high growth and greater earnings in the future.
Type of PE ratios
There are 2 types of PE ratio we may use for valuation. Which is Trailing PE and Forward PE.
- Trailing PE
- Trailing PE ratio is most commonly used. Because it offers the most accurate valuation of a company. Using historical earnings.
- Forward PE
- Forward PE ratio is less commonly used. Because it compares current prices to projected earnings in the future. The projected numbers can change or be adjusted to help the company look more attractive.
Case Study: Hibiscus Petroleum & Bumi Armada
For instance we are taking Bumi Armada and Hibiscus Petroleum for the purpose of comparison. Although these two companies are slightly different to one another. Hibiscus Petroleum is engaged in the exploration, development and production of oil and gas. While Bumi Armada is engaged in providing offshore services which include Floating Production and Operations (FPO) and Offshore Marine Services (OMS). But they are still within the same industry which is offshore crude oil/gas production entity.
By looking at Trailing PE:
By looking at Forward PE:
Hibiscus Petroleum share price is expected to move upward than its current position. As of today, the share price is RM 0.905. Therefore, its price will move to RM 1.30 in the future. This is 43.64% return. Meanwhile, as for Bumi Armada, its price as of today is RM 0.350. Therefore, its price will move downward to RM 0.311. This is 12.54% loss.
Benefit and drawback of using PE ratio
- PE ratio allows investors to compare a stock within industry average and with that of competitors within the same industry.
- The current PE ratio can be compared to that of past ratios. If it stays somewhat constant but earnings have risen, then the share price is undervalued.
- PE ratio doesn’t take into consideration a company’s debt or financial structure. EPS is affected by a company’s accounting practices such as depreciation and amortisation methods, and its tax system.
- A low PE ratio doesn’t mean that a stock is a good buy. The company could be cheap due to a number of reasons such as it is losing customers or market share.
- How Finance Works
- SIDC Financial Statement Analysis & Asset Valuation, Module 7
- Investment and Retirement Planning, Module 3
- Seeking Alpha