Know how to Valuate companies with Price to Earnings Ratio

In previous articles, we talked about the methods of evaluating medium and family companies, specifically about the discounted cash flow method, and it turned out through this study that it is one of the evaluation tools, but there are other tools that should be paid attention to, and this is what we will talk about today …

Imagine that you want to buy a used car. You will compare several different cars, consider factors such as make, model, mileage, price. But, how to decide if the price of the car is reasonable or too high

This is exactly what investors do when they want to evaluate a company. Instead of comparing cars, they compare companies. And one of the tools they use is the“profitability multiplier“.

Simply put, the profitability multiplier is a number that tells us how many times we should pay the share price of a company compared to the profit that this company makes per share, which helps investors determine whether a stock is undervalued or overvalued.

* Comparison: the profitability multiplier helps to compare different companies in the same industry. If the profitability multiplier of a particular company is too high compared to its peers, this may mean that its share price is too high relative to its earnings.

* Valuation: helps in assessing whether the company's share price is reasonable or overvalued.

* Forecast: it can give an idea of investors ' expectations about the company's future growth.

But, there are a few things to remember:

* Not the only indicator: the profitability multiplier is just one of many indicators that must be taken into account when evaluating a company.

* Varies from industry to industry: the natural profitability multiplier varies from industry to industry.

* Influenced by external factors: the profitability multiplier can be influenced by factors such as the state of the economy, Market Forecasts, world events.

How to calculate the profitability multiplier

Profitability multiplier = share price ÷ profit per share

* Share price: it is the current price at which the company's share is traded on the market.

* Profit per share (EPS): is the total profit of the company divided by the number of shares in circulation. This figure represents the amount of profit that returns on each share.

The profitability multiplier is calculated using the following equation:

PE = share price / EPS

Where :

* Stock price: is the current price of the stock in the market.

* Earnings per share (EPS): calculated by dividing the company's net profit by the number of shares issued.

Simplified example

Suppose we have a company XYZ, and its market share price is EGP 100, its net profit is EGP 2,000,000 and the number of issued shares is 1,000,000 shares.

1. Calculation of earnings per share (EPS):

​​​​EPS = 2,000,000 / 1,000,000 = 2 EGP per share

1. Calculation of the profitability multiplier (P / E):

PE = share price / EPS = 100/2 = 50x

Interpretation of results

* Profitability multiplier of 50: means that investors pay 50 pounds for each pound of the company's profits.

* Investment valuation: a low profitability multiplier is usually considered attractive, as it means that the investor pays less for each unit of profit. While a high profitability multiplier may indicate that the stock is overvalued, or the market expects significant earnings growth in the future.

* Easy to use: it is considered one of the easiest tools to understand stock valuation.

* Relative valuation: it can be used to compare companies within the same sector or industry.

* Trend analysis: it can help to understand the general trends in the market by comparing profitability multipliers over time.

Observations

* The profitability multiplier should be used in combination with other assessment tools, since it is not considered a sufficient measure on its own.

* The results may be influenced by factors such as debt and expected growth levels, so the full context of the company should be analyzed.

In this way, the profitability multiplier is an effective tool for investors to help them make informed investment decisions.

1. The telecommunications sector: it is considered one of the leading sectors in achieving a high profitability multiplier, as companies in this sector show stability in revenues and profits.

2. The gas and petroleum sector: it also enjoys a high profitability multiplier due to the constant demand for energy, reflecting the strength of profits in these companies.

3. Banking sector: banks often show high profitability multipliers as a result of good financial performance and an increase in the volume of deposits and loans.

4. Fintech sector: with the increasing reliance on technology in financial transactions, companies in this sector have begun to achieve high profitability multipliers.

Illustrative example

For example, if a telecom company makes stable profits and has a profitability multiplier of 15, it means that investors pay 15 pounds for every pound of profit that the company makes. While enterprises in other sectors such as industry or agriculture may have lower profitability multipliers, indicating that investors expect greater growth or more stability in profits from enterprises in sectors with a high multiplier.

Abstract

Sectors such as telecommunications, gas, petroleum and banking are among those with a high profitability multiplier, which makes them attractive for investors looking for stable and profitable investment opportunities

1. Basic materials sector: such as mining and chemical companies, where profits may be volatile due to commodity price fluctuations.

2. Real estate sector: real estate projects often have a low profitability multiplier, especially in markets experiencing stagnation or declining demand.

3. Heavy industry sector: such as machinery and equipment manufacturing companies, where they may face challenges in growth due to global competition.

4. Public services sector: such as electricity and water companies, where profits are stable but growth is limited, resulting in a low profitability multiplier.

5. Retail sector: especially companies that are experiencing competitive pressures or a decline in sales.

Illustrative example

If a company in the basic materials sector has a profitability multiplier of 5 times, while a company in the technology sector has a profitability multiplier of 20 times, it means that investors are ready to pay 5 pounds for every pound of company profits in the first sector, while they pay 20 pounds for every pound of company profits in the second sector.

Abstract

Sectors such as basic materials, real estate, heavy industry and public services are among those with a low profitability multiplier, which may indicate potential investment opportunities for investors looking for attractive valuations.

How can I use the profitability multiplier to identify sectors with investment opportunities in the Egyptian market

The profitability multiplier (P / E Ratio) can be used as a tool to identify investment opportunities in the Egyptian market by following the following steps:

* Calculate the profitability multiplier for each company in the desired sector using the equation:

PE = share price / EPS

* Identify companies with a low profitability multiplier: companies with a profitability multiplier below the market average or lower than their competitors may indicate good investment opportunities.

* Compare profitability multiplier between different sectors: profitability multiplier can be compared for different sectors such as telecommunications, banking, and basic materials. For example, the telecommunications sector may have a higher profitability multiplier due to the expected growth, while the basic materials sector may have a lower profitability multiplier.

* Analyze the financial performance of companies with a low profitability multiplier: other financial factors such as revenue growth, profit margins, and debt levels should be considered. Companies with good financial performance with a low profitability multiplier may be good opportunities.

* Analysis of the average profitability multiplier of the market: if the average profitability multiplier of the Egyptian market is low, this may indicate that the market as a whole is undervalued, which provides opportunities for investors.

Illustrative example

If you have the banking sector in the Egyptian market:

* Bank A: share price 50 EGP, EPS = 10 EGP, P / E = 5.

* Bank B: share price 100 EGP, EPS = 8 EGP, P / E = 12.

In this case, Bank A has a low profitability multiplier (5) compared to bank B (12), which may indicate that Bank A represents a better investment opportunity if other financial factors support this.

Abstract

Using the profitability multiplier as a tool for identifying investment opportunities requires careful analysis to compare different companies and sectors. By focusing on companies with low multipliers and analyzing their financial performance, investors can make informed decisions in the Egyptian market.

Article link on alalamelyoum

have a free consultation from the certified chartered accountants click here