The PER ratio: calculation, meaning, use, advantages and disadvantages

The PER ratio: calculation, meaning, use, advantages and disadvantagesThe PER, also known as the P / E ratio, Price-to-Earnings ratio or Price-Earnings ratio is undoubtedly the most used ratio in the relativa valoración of actions. However, it is necessary to use it with a series of precautions so as not to fall into value traps that can make us lose a lot of money. In this article we will analyze the PER ratio, its calculation, its meaning, how to use it and the advantages and disadvantages of its use in fundamental analysis.

Cálculo of the ratio PER

Calculating the PER ratio is extremely easy. You just have to divide the capitalization bursátil of the company between your net profit.

PER = Market capitalization / Net profit

Since the market capitalization equals the price per share times the number of shares and the net profit equals the earnings per share times the number of shares, the PER can also be simplified as follows:

PER = Price per share / Net Earnings per share

As you can see, the calculation is the simplest thing in the world. In addition, it is common that the PER is already calculated automatically in most of the financial information websites.

What does the PER mean?

The PER shows the number of years of benefits that a company needs to recover the money invested in the purchase of its shares if the earnings per share were constant. Let's see it with an example.

Suppose a company's shares are trading at € 70 per share and its net profit per share is € 10. Your PER would be 7, which is the result of dividing 70 by 10. If the company kept the net profit constant at 10 euros per share, it would take 7 years to produce the necessary profits to cover the money invested in the acquisition of its shares.

How to use the PER ratio?

Like the rest of stock market ratios, the PER should be used comparatively. The question you must ask yourself is: what should we compare it with?

  • With the historical average PER of the market, which is approximately 15 times.
  • With the average PER of the market
  • With the average PER in your sector
  • With the historical average PER of the action

It is advisable to take into account all comparisons. For example, during dotcom bubbleSome technology stocks that traded at a PER ratio of 75 were considered cheap by some analysts, since the PER of some comparable companies was more than 200. However, if we compare their PER with the historical average PER of the stock market of 15 times, the company would trade at a price 5 times higher.

Advantages of PER

The main advantage of PER is that it relates two essential data when valuing a company, the price at which a share is traded and its net profit, giving us in a single figure a first impression of the degree of undervaluation or overvaluation of the company.

As we have already seen, its calculation is very simple. In addition, the main financial information websites usually calculate this ratio automatically, so normally we will not even have to bother calculating it.

Disadvantages of PER

PER is one of those ratios that are especially misleading. Its use is especially contraindicated in cyclical companies when we are in the high part of the economic cycle. For example, a company may have a PER 10 at the top of the economic cycle and appear "cheap", but if the economy falls and this leads to a 50% reduction in profits, the PER will double to 20, becoming a company "face".

Another problem is that while other figures, such as cash flows, are not accounting manipulable, net profit can be the victim of accounting manipulation. And I am not referring to anything illegal. For example, write-offs or depreciations can make a net profit higher or lower based on the choices of the management team.

Finally, do not forget that the PER ratio is not a crystal ball. It is important to bear in mind that stocks should never be bought based solely on the PER, since we could fall into so-called value traps (companies that seem cheap but are not really cheap, which I will talk about another day). It is essential to always combine financial analysis with competitive analysis to determine if the company in which we intend to invest has sustainable competitive advantages in order to maintain its position in the market that allows it to maintain or even increase its long-term profits.