Trading on the stock market is not a random walk and there are many fundamental factors at play that can impact the price of a stock. The price-to-earnings ratio, or P/E ratio, is one of them, which is basically the price of a share divided by earnings per share (the profit per share made by the firm).
If stocks of a company are trading at a high price, it does not necessarily reflect the soundness of the company's earnings. In other words, bullish stock prices in the short term may not be necessarily backed up by strong earnings. Similarly, bearish stock prices in the short term may not be an indicator that the company's earnings are sinking.
While in the short term stock performance is more driven by sentiment, in the long run it has to catch up with its earnings, says MR Raghu, Senior Vice-President (Research), Kuwait Financial Centre (Markaz).
P/E ratio is a tool to assess whether a company's share is reasonably priced compared to its earning. If the share price of a company is well below the firm's earnings, it means the stock is undervalued but it may rise in the future. Similarly, if the price of a stock is above the company's actual earnings. the stock is considered overvalued whose price can fall in the future. For instance, if a stock has a high P/E multiple of 10, it means for each share the investor is paying 10 times the earnings of that share.
But should an investor look solely at the P/E ratio to decide whether to invest in a stock or not and ignore the long-term fundamentals of the company?
No, say experts.
If P/E ratio was the only yardstick life would be far simpler. A low P/E ratio is not necessarily attractive (there must be a reason why the price is low) or a high P/E ratio is not a bad thing in itself (again there must be a reason why there is so much interest in that stock). While P/E ratio can be a starting point, estimating future performance of the company is the key to identifying winners, said Raghu.
The P/E ratio does not tell you about the profit and loss of the company, rather it tells you more about investors' expectations about the company. There is more risk with a high P/E ratio stock, because it is the expectation of investors and the expectations can be right or wrong, says Paul Cooper, Managing Director, Sarasin-Alpen and Partners, Dubai.
So if one does not look at the fundamentals, one cannot know whether the market has got that right. Fundamentals are crucial and investors need to look at the fundamentals and need not only rely on the P/E ratio, he added.
If the P/E ratio is high, it tells about the profitability of the company today and investors' expectations about the company in the future. It also means investors are optimistic about the future in general. If the P/E is low, investors are pessimistic about the future. But information about P/E ratio only is not enough to determine whether the stock will do well or badly, said Cooper.
Companies with a high P/E ratio can do well and so is the case with companies with low P/E. If an investor wants to increase the chances of making money, he needs to look at the fundamentals and determine whether the company would do better than the consensus, he added
Cooper said making an investment decision just on the basis of balance sheets is also not enough as it is not a forward-looking document, rather just a snapshot of how the company looks on the day the accounts were drawn up.
A good company will give a good share price over the long term. But in a volatile market, looking at the short-term valuation may not give the right picture.
If a company has been trading on a long term P/E multiple of 10, but the valuation currently is 15, an investor should make it sure whether it is too late to invest in that company. They should do a reality check and wait for the share price to settle and go back to its fundamentals, said Gary Dugan, Chief Investment Officer, Emirates NBD.
Experts say whether an investor should look at the P/E ratio or the long-term fundamentals of the company depends on the investor's objective. In other words, whether the investor is looking for income from the shares, or capital growth, or a mix of both.
The P/E ratio is the relationship between the price of a share and the expected dividend. If the price is 10 times the most recent dividend, the share has a P/E ratio of 10.
The P/E ratio is a good guide to the value of a share, just as the rental income is a good guide to the value of a property. In terms of the fundamentals of a business all the other factors need to be considered also, said Steve Gregory, Managing Partner, Holborn Assets, Dubai.
An investor needs to look at many factors before making up his mind to invest in any company listed on a stock market, experts say.
There are many things that influence a market or the share price of a company in a market. These include inflation, interest rates, business cycles, governmental and fiscal policies, money supply, exchange rates, technology changes, globalisation, social issues, and reputation, said Gregory. Therefore, to be clear about the objectives and the risks one is willing to take to achieve them is one of the important considerations, experts say.
There may be lots of reasons one would want to wish to invest in stock markets or equities. One can try for a short-term speculative strategy or can try to build up a portfolio in order to have a long-term sustainable income. It depends on what the investor's objective is for investing in equities, said Cooper.
The investor needs to make sure whether he has invested a small amount of money for short-term gains or is he looking for a diversified portfolio for a very low volatility growth. He also needs to confirm whether he is looking to live up the income or is he seeking to maximise capital growth. Only then will he be in a position to know what to buy and whether it is a good time to do it, he said.
Heinrich Weber, Executive Vice-President of one of Switzerland's leading private banks and author of The Ultra High Net Worth Banker's Handbook, also said an investor needs to look at factors such as the fundamentals of the company, the credit of the firm, how the company is valued, prospects of the company's growth, and the sort of financing it has.
The P/E ratio is a good measure, but an investor can have a much better understanding about the company if he includes these different parameters. It is dangerous if an investor just goes by the low or high P/E ratio. A company can have a low P/E ratio because of low valuation, but it can have a low P/E ratio also because it is operating in a sector or in a market where earnings are following an overall negative trend, he said.
Avoid putting all the eggs in one basket
Avoiding losses on stock markets is what every investor looks to do, but this is not always easy to achieve. However, diversity of portfolio and spreading the risks can minimise losses, according to experts.
An investor can have less upside potential if he diversifies, but at the same time he has much less downside potential, says Paul Cooper, Managing Director, Sarasin-Alpen and Partners, Dubai. "Under normal circumstances, we would advise clients to spread their risks. So if they are willing to buy 10 companies' shares, we would advise them to buy shares from 10 different sectors from different markets and different countries," he says.
If one chooses the portfolio of stocks carefully, one can have a good balance of upside risks and downside protection. If, however, an investor puts in all the 10 shares in 10 companies in one stock market and in one country, it can be a risky decision because he is concentrating his positions and everything that will affect the country will affect all the 10 companies, says Cooper.
Diversifying investments between companies and industries is key when constructing a portfolio, says Jakob Thomsen, CEO of Saxo Bank Dubai.
Look at the correlation between industries and companies and seek to manage your risk. In equity trading as with anything else, risk and return go hand in hand. Put in stop-losses on every trade and stick to them. Discipline towards the strategy, above everything, is key to manage risk and return, he says.