A low P/E looks cheap, a high one expensive. It is not that simple. Companies with fast-growing profits often have a high P/E because investors pay for future profits too. With , profit swings with the economy – there the P/E is often lowest at the profit peak. A P/E only tells you something in comparison: with similar companies and with earlier years.
The model company through the cycle
In the exercise, the company earns exactly €8 per share in its peak year 4 at a price of €72 – P/E 9. In the weak year 7 it is €1 at €30 – P/E 30. Looking only at the P/E, you read “cheap” at the peak and “expensive” in the trough. Afterwards the profit fell from the peak, and it rose again from the trough.
Factoring in growth
A P/E of 30 can suit a company whose profit grows 25% every year – and be too expensive if the growth fails to come. A rough aid is the PEG: P/E divided by the expected profit growth in percent, here 30 ÷ 25 = 1.2. The expected growth, however, is itself only an estimate.
Comparing sectors
Utilities and banks often have lower P/E ratios than fast-growing software companies, because growth and risk differ. So compare within a sector and with the company’s own values from earlier years. A P/E alone is not enough for a decision to buy or sell.