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CK Choy.

Market Sense 市场意识: Putting P/E ratio into perspective
Be decisive, Be patient, Don’t be greedy, Don't be stubborn

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You should seek advice from a financial adviser regarding the suitability of the investment products mentioned, taking into account your specific investment objectives, financial situation or particular needs, before making a commitment to purchase the investment product. In the event that you choose not to obtain advice from a financial adviser, you should assess and consider whether the investment product is suitable for you before proceeding to invest.

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Saturday 2 July 2011

Putting P/E ratio into perspective

December 26, 2010 by financiallyfreenow
A low P/E ratio doesn’t necessarily mean that the company is undervalued and is a prospective buy. On the other hand, a high P/E ratio also doesn’t mean that the company is overvalued and we should chuck it aside.
A company with low P/E ratio may not mean that it is attractive (or undervalued) due to the following reasons:
  • company has uncertainty over its prospects for earnings
  • company is operating in a highly cyclical sector
  • company is serving volatile markets
  • company is operating in a sector with overcapacity and weak pricing power
  • company is operating in a sector with low returns consistently
  • company operating in a mature sector, with little prospect for growth
  • company is ex growth
  • company has poor management with no convincing strategy for growth
  • company has poor cash generation
  • company has a weak balance sheet
Whereas a company with a high P/E ratio may not mean that it is overvalued due to the following reasons:
  • company has an excellent growth record and prospects for growth
  • company is operating in a high-growth sector
  • there’s high confidence in company’s forecasts
  • predictable/stable returns
  • strong market share
  • high barriers to entry
  • strong pricing power
  • high margins and excellent returns
  • superior management with excellent growth strategies in place
  • strong cash generation
  • strong balance sheet
P/E ratios also have advantages and disadvantages.
Advantages of P/E ratio:
  • easy to compute
  • widely used so it’s easy to find a company’s P/E ratio
  • takes forecasts into account
  • earnings is a measure of what is generated for shareholders
Disadvantages of P/E:
  • does not take debt/financial structure of company into account
  • gearing up/share buy-backs increase earnings (‘financial engineering’)
  • earnings are prone to manipulation by management
  • does not take cash generation into account
  • presents difficulties in assessing quality of earnings
Thus, P/E ratios must always be compared with companies of the same sector and with the overall market P/E. Various matrices must be looked at (not only P/E ratio) before investing in a company as well.
Posted by ckchoy77 at 14:50
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