PE ratios

I think I have an understand of the PE ratio and what it means… but in case I’m wrong can some explain it to me in a very basic way?

While it can’t paint a complete picture PE is perhaps the simplest way to measure optimism / gauge how expensive something is.

PE tells you how much you have to pay for a year’s earnings.

If there are 2 machines that make a £1 coin every year

  • A is very good, it’s very reliable and in future it might make them even faster
  • B is a bit dodgy, it’s getting slower and there’s a chance it might break entirely

People might be willing to spend £100 on A but only £10 on B because it’s riskier. A has a PE of 100, B has a PE of 10

A high PE generally implies that the market is expecting earnings to increase in future hence investors are willing to pay a significant premium for the current earnings.

A low PE means the market is looking less favourably and is therefore unwilling to spend so much, they expect to recoup their investment sooner as maybe they have a less optimistic outlook in the longer term.

I think E/P ‘Earnings Yield’ (instead of P/E) is a more intuitive way of thinking about the exact same thing. Very simplistically you can compare this to the interest rate on a bond.

Intel has a P/E of 13.2 or E/P of 7.6%
Apple has a P/E of 35.5 or E/P of 2.8%
Tesla has a P/E of 1101 or E/P of 0.09%

Clearly no one would risk their money for 0.09% yield (when you could get more for a ‘risk free’ government bond) so they must be anticipating massive growth and are willing to look a very long way into the future.

Conversely 7.6% is very good in the current climate, so investors must be anticipating some decline or risk making them unwilling to look so far ahead and earn their money back sooner.

Investopedia has lots of definitions / explanations for investing & finance terms:

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Nice on @Cameron :ok_hand:

Wow, I had no idea INTC was that good a P/E!

I have a very tech heavy portfolio, but Intel never made the cut for me for personal reasons, so it’s interesting that that’s also borne out in market sentiment.

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Nice explanation @Cameron :+1: the one thing I would add although just an opinion is not to be guided by the P/E alone or highly. In the example above

Intel has a P/E of 13.2 or E/P of 7.6%
Apple has a P/E of 35.5 or E/P of 2.8%
Tesla has a P/E of 1101 or E/P of 0.09%

you could think Tesla was a shocking investment at 84X worse than intel but in reality I would hazard a bet that this is not how the market will actually play out.

I guess the answer is the same as in all investments that if there was a magic formula we would all be rich :joy: