The Price-Earnings Ratio (or PER) is often referred to as an indicator of a company's valuation. The PER compares the price of a stock to earnings per share. The higher it is, the more you will pay for a company in relation to its fundamentals. This is the indicator most followed by the mass of investors, it has Certainly advantages, but also many disadvantages.
Aside from the strictly financial context of the PER, it is interesting to look at its psychological component. Indeed, when a stock increases in value, this may be because profits are increasing and therefore the price is adjusted accordingly to maintain a constant PER. But it may also be due to the fact that investors are prepared to pay more for a company because they expect something from it. Very often, particularly during a bull market, we therefore see a kind of headlong rush, with profits increasing of course, but with a PER that is nevertheless climbing more and more, because there are people, more and more of them, who are hoping for something even better in the future.
The higher the PER, the higher the expectations. It's like being a die-hard U2 fan. You'd be willing to pay a lot of money for a concert ticket and even travel halfway around the world. On the other hand, if a local band was playing near you, you might agree to go see them if the entrance was free and you got away with a few beers. Now imagine, you've 'flown down' to Australia to see the legendary band and you find out that Bono has just had an accident and all the upcoming concerts are cancelled. Even if the ticket is refunded, you're hugely disappointed and you buy your plane tickets and hotel rooms for nothing. The higher your expectations, the greater the moral and financial loss. On the other hand, imagine yourself sipping your beer and listening to this unknown local band. It turns out they do incredible covers and are incredibly energetic. The crowd is excited and wants more. You're having a great night. The lower your expectations, the greater the chances of a pleasant surprise and the lower your financial risk.
It's exactly the same on the stock market. With a high P/E ratio, expectations are enormous, so much so that a result that is just in line with what was predicted by the analyses can even represent a disappointment and cause the stock to fall. The stock must continue to line up good surprises for its price to continue to rise. Inevitably, at some point, this will no longer be possible. When profits fall below expectations, it's a sure-fire downfall. Conversely, investors expect nothing from a low P/E ratio. Even bad results have no impact on the price. Better still, the "risk" of a good surprise is necessarily quite high in this context, and when this is the case, the price tends to react strongly upwards.
Rather than hoping for hypothetical future outcomes, let us focus on the reality of the present time. This avoids disappointed hopes. As Seneca said: "The greatest obstacle to life is expectation, which hopes for tomorrow and neglects today."
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Great article! On the one hand, a high P/E does indeed mean high expectations, even too high, and the risk of disappointment is relatively high. On the other hand, we see that a high P/E generally means that investors have identified a high-quality company and are willing to pay a premium – most often rightly so.
The qualities of a Givaudan justify, for example, a PER twice as high as for Adecco. The expectations for Givaudan are certainly higher, but practice shows that such a company meets them much more often than another such as Adecco.
Finally, we must not forget that the PER (like any other ratio) is not a value fixed in time. A 2019 PER of 25 is for example not necessarily exaggerated if the following year the profits increase by 20%, thus mechanically bringing the 2020 PER back to 20.
Right. Quality has a price. The question is what it is. It's all about proportions, about value for money.
You can indeed buy a company with a PE of 10 too expensively because its FCF diverges from its profits, because its competitors are better than it, because its field is obsolete, because its staff is outdated, or for x other reasons. You can also buy a company with a PE of 25 cheaply because the assets are worth more than the capitalization, because the company is just going through a bad period, because the FCF is huge, or for x other reasons.
If we come back to the comparison with U2, it's the same. We're ok with paying the price. It's normal to line up tickets for a band that we know and that has proven itself for decades. Often, we find exactly what we're looking for. A great evening, a warm audience, good music and nice effects. We're rarely surprised, neither for good nor for bad. It's U2, in all its splendor. We don't expect anything else.
But if it were to fail, we would be very disappointed because our expectations are at least as high as the price we paid for it.
Along the same lines, if the guitarist in the local band has had too much Fendant, it will break our ears and we might go and drink our next beer somewhere else. Our expectations are so insignificant with the local band that our risk is quite low. On the contrary, the chances of a good surprise are quite high.
It's all a question of proportion, but also of probabilities. Our risk is necessarily higher with a higher PER.
Thank you for this article.
The problem with the PER is that it corresponds to the present and is not a guarantee for the future. So, indeed, the higher it is, the higher the risk of disappointment - and therefore of loss on the value of the share.
Moreover, the times we live in are very strange. With central banks having created a lot of liquidity since 2008 and low or even negative interest rates having their effect, the money supply is placed where it can, if not to win at least to try if possible not to lose. This is one of the factors that makes the markets at their highest and disconnected from a certain reality. The investor invests to invest and too bad for high PERs and other indicators in the red. How will this end?
By a nice big bang like every time. The financial planet is suffering from amnesia…