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PRICE/EARNINGS RATIO AS YOUR INVESTMENT YARDSTICK

This article is reproduced with permission from
Normandy Advisory Services Sdn. Bhd (Licensed Investment Advisor)
15th Floor Menara Multi-Purpose, No 8 Jalan Munshi Abdullah, 50100 Kuala Lumpur
Tel : 03 - 469 5560 Fax : 03 - 294 5561


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Like other local newspapers, the Star publishes the price earnings ratio on the daily quote sheet for local stocks.

The price/earnings ratio, commonly identified as P/E, PER or the earnings multiple basically relates a company with its earnings and sales growth.

Simply, the P/E is calculated by dividing the market share price by the company's earnings per share (EPS). The P/E tells an investor how many times the price is a multiple of the earnings The P/E normally rises in tandem with the stock price, meaning that when the stock price rises, the P/E will rise too and vice versa.

The P/E ratio is widely used as a measurement by fundamental-driven investors to identify good investment opportunities. You may be one of those who use the measurement as part of your investment tools.

Calculating the P/E is simple but the more complicated task is comparing it with other figures and interpreting them. Analysts employed by stockbroking firms spend most of their times evaluating the performance of companies of various backgrounds. One of their routine tasks of course includes evaluating the P/Es of these companies.

Different analysts have different interpretations of the P/Es. So how do you interpret the P/E of a company? Let us take an example. Suppose there are two companies listed on the Kuala Lumpur Stock Exchange (KLSE), Company A and Company B with the P/Es of 5 and 20 respectively.

Analysts may interpret that Company A is selling 5 times its earnings while Company B is selling 20 times its earnings usually written as 5x or 20x. Company A's P/E of 5x means that the market values the stock at RM5 for every RM1 of earnings while Company B is valued at RM20 for every RM1 earnings.

An analyst may find that Company A is more attractive since it costs less for the same earnings of RM1. Another analyst may reason that Company B is more attractive as higher P/E means that the stock is more valuable in that it has a higher potential to deliver attractive returns.

So, which one is the best? Low or high P/Es? High P/E basically means having high expectations for earnings. If the earnings growth expectations are not met as implied by the high P/E maybe due to certain factors such as ineffective management or poor marketing efforts, investors are most likely to dump the stock in the future.

High P/E stocks do not necessarily outperform the market and investors face the danger of buying at peaks. However, it is also equally true that high P/Es generally reflect investors confidence in the stocks. In many cases, some of these stocks do manage to deliver good and secured returns over the long-term.

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