Investing may seem complicated, but it doesn’t have to be. There are tools that help us understand whether a stock or a market is expensive, cheap, or well valued. Here we are going to talk about three of them: the PER, the PEG and the CAPE. Although their names sound technical, they are easy to understand when we explain them step by step.
The PER: A quick thermometer of the price of a share or a market
The Price Earnings Ratio (PER) indicates the ratio between the price of a share and its earnings per share. It tells us how much investors are paying for each euro or dollar of a company’s profit. It is calculated as follows:
PER = Share price / Earnings per share
Let’s imagine that share A costs 20 euros and generates 2 euros of profit per share. The PER would be 20 / 2 = 10. This means that investors are paying 10 euros for each euro of profit.
On the other hand, share B costs 25 euros and generates 3 euros of profit per share. The PER would be 25 / 3 = 8.3. This means that investors are paying 8.3 euros for each euro of profit.
A high P/E could mean that investors have high expectations for the future, or that a company’s share price is expensive relative to the earnings it generates. A low P/E could be a sign that the stock is cheap, although it may also indicate problems in the company.
If the companies were in the same sector, investors would be willing to pay more (per unit of profit) for A than for B. But it could also be interpreted as meaning that A is more expensive than B.
Although it is used to determine the valuation of a company, it is also used for indexes. For an index, the PER would indicate how expensive or cheap the shares of an index are in terms of their profit or, in other words, the multiple they are willing to pay per unit of profit.
Note: PER, although it is an acronym in English, is the most used terminology even in Spanish, which as we have said stands for “Price Earnings Ratio”. Literally translated, it would be the Ratio between Price and Earnings per share. In English, we can also see the acronym P/E. The PER can be calculated with the current earnings per share or with the future earnings per share. When the latter is used, it is called “Forward P/E”.
- The PEG: Adjusting the P/E ratio to growth
PEG (Price Earnings to Growth) goes one step further. It considers not only price and earnings, but also the company’s growth. It is calculated as follows:
PEG = P/E / Earnings growth rate
If company A has a P/E of 10 and is growing at 10% per year, the PEG would be 10 / 10 = 1. This indicates that the share price is in line with its growth. If company B has a P/E of 8.33 and is growing at 20%, PEG would be 8.33 / 20 = 0.42. Therefore, B, in addition to being cheaper in terms of P/E, its PEG indicates that it is undervalued compared to A, since it is growing more, or it has some problem that makes investors willing to pay less for B than for A.
In general:
- if the PEG is less than 1: The stock could be cheap considering its growth.
- if the PEG is greater than 1: It could be expensive or overvalued.
The PEG is very useful for analyzing companies in sectors such as technology, where growth is key and where there are very high P/Es.
CAPE: an adjusted P/E
CAPE, or Cyclically Adjusted Price/Earnings Ratio, analyzes markets or indices rather than individual stocks. It uses the average earnings over the last 10 years (adjusted for inflation) to calculate whether the market is expensive or cheap:
CAPE = Market price / Adjusted 10-year average earnings
It gives us an idea of how the market has behaved over time, eliminating the distortions of exceptional years. You can see the CAPE chart from 1900 to the present with more relevant dates.
For example, if the CAPE is very high, it could be a sign that the market is overvalued (as in the bubbles of 1929 or 2000). If it is low, there could be good opportunities, as in 2006, at the end of the great financial crisis. At the time of writing this post it would be at a historically high level at 38 times, clearly above the historical average which is 17.6.
Note: the CAPE was developed by Robert J. Shiller. You can find more information on this ratio here.
Conclusion: Three useful but not definitive tools
PER, PEG and CAPE are like three different lenses through which to look at an investment, be it a stock or a stock index. Each has its strengths:
- The P/E: It gives us a quick view of whether a stock or an index looks expensive or cheap.
- The PEG: helps you understand if the price makes sense based on growth.
- The CAPE: gives a long-term view adjusted for indices.
None is perfect on its own, but together they can help you make more informed decisions.
In inbestMe we consider important to know these indicators, and therefore we do this kind of informative posts as we did with the technical analysis. But we do not advise trying to use them to make a timing of the market or a stock. None of them has proven to be definitive by itself and as we have seen, they can have contradictory interpretations. In addition, market situations, or future expectations of stocks and markets, can significantly condition these indicators. That is why at inbestMe we believe it is best to base our investment decisions based on our financial objectives and horizons.
