What Is The Ideal PE Ratio?

The price-to-earnings (PE) ratio is a financial ratio that measures the price of a stock relative to the company’s earnings. PE ratios are used by investors to determine whether a stock is overvalued or undervalued.

Some momentum investors prefer to purchase companies that have a high PE ratio, expecting the stock to grow very rapidly. Others, typically investors more inclined towards value, prefer a low PE ratio, expecting the stock to provide stability and income. All else being equal, a lower PE Ratio means that the stock is cheaper, and should therefore be viewed as a better opportunity. Is this always the case, and what is the ideal PE ratio?

Ideal PE Ratio and Growth

The growth profile of a business affects the PE ratio at which it is typically quoted in two ways. First, faster-growing companies tend to have higher PE ratios than slower-growing companies. Second, investors typically require a higher return from faster-growing companies, which results in a higher PE ratio.

A high PE ratio can also indicate that a stock is overvalued, meaning that the share price is too high relative to the company’s earnings. However, a high PE ratio can also be justified if the company is expected to grow very rapidly in the future and outpace the expensiveness of the PE ratio. Ultimately, each investor must decide for themselves whether a high PE ratio is good or bad.

How Margin Assumptions Impact Future Earnings And Modulate PE Ratio

Margin assumptions can have a significant impact on future earnings. For example, assume that a company has $100 in sales and $50 in expenses (excluding taxes). The company’s profit margin would be 50%. If the company’s expenses increase to $60, the profit margin would decrease to 40%.

Therefore, if I’m paying for a stable revenue company at a PE Ratio of 10 today, and if an increase in costs will decrease the margins by 20% (the previous example), my Trailing PE Ratio of 10x may really be a Forward PE of 12.5x.

What Is The Difference Between A Trailing PE Ratio And A Forward PE Ratio?

The trailing PE ratio uses real earnings from the past 12 months. The forward PE ratio uses earnings estimates for the next 12 months. One is concrete, the other one is full of assumptions, which may prove right or wrong.

How Terminal Value Assumptions Affect PE Ratios

Terminal Value estimates the future cash flows of the business and then discounts those cash flows back to the present. The higher the terminal value, the higher the PE ratio. Conversely, the lower the terminal value, the lower the PE ratio.

This is because the terminal value is used to calculate the value of a company’s future cash flows. The PE ratio is simply the present value of a company’s share price divided by its earnings per share.

Assuming all else equal, a higher terminal value would result in a higher present value of future cash flows, and thus it would encourage a higher PE ratio.

Conversely, a lower terminal value would result in a lower present value of future cash flows, and thus favorize a lower PE ratio.

Of course, there are many other factors that affect PE ratios besides terminal value assumptions. All else equal, the impact of terminal value on PE ratio is clear.

Three Examples Of How PE Ratios, Margins And Growth Interact

Here are 3 investment cases. If these were TSX companies, they would all be good Canadian investments, but the latter two are better in terms of Internal Rate of Return (IRR). The first one, Company A, is a stable margin company growing at 5% a year quoted at a PE of 10, sold 10 years later at the same ratio.

The second case, Company B, a superior one in terms of IRR, is a lower margin company growing at 10% with a PE of 12, but sold at a normalized PE of 10, 10 years later, once growth prospects are less interesting.

The third case, Company C, also a better one, is of a lower margin company that improves its margins but loses on its PE ratio because there is no longer margin improvement potential (also 12 to 10).