What is a P/E ratio? The one number that tells you if a share is cheap

Five minutes a week that makes you smarter and calmer about your own money — plus a look at what I’m actually doing with mine…

One share of Berkshire Hathaway will cost you $765,020. One share of Nvidia will cost you $225. For the price of the Berkshire share you could buy three thousand Nvidia shares.

So which is the expensive one?

The honest answer is that neither number tells you. A share price on its own is one of the least useful figures in investing, and yet it's the one on every app and every news bulletin.

This week's letter is about the number that does tell you whether a share is dear or cheap, and it's actually very simple.

Oil fell for six days running and crude dropped back below $100 a barrel after Trump called a three-hour meeting with Iran at the UN "very productive". I don’t think they said the same, and the Strait of Hormuz is still shut.

A week after the Fed's rate rise, America's borrowing costs kept climbing: the five-year Treasury yield touched 5% for the first time since 2007. Shares wobbled, but the S&P 500 closed last night at 7,706, higher than before the rise.

The portfolio pages are refreshed with last night's prices, as usual: timswealthletter.com/my-portfolio

Forget shares for a moment and think about buying a whole business. Say a pub is for sale at £1 million. That price means nothing until you ask what the pub makes. If it makes £100,000 a year in profit, you're paying ten years of profit for it. If it clears £50,000, you're paying twenty. Same price, but the second pub is twice as expensive.

A share is a slice of a business, and it works exactly the same way. That's the P/E ratio: the price of a share divided by the profit the company earns per share. It's the number of years of profit you're paying for (earnings is simply another word for profit).

Take two shares everyone in Britain has heard of. Marks & Spencer costs £3.72 a share and is on a P/E ratio of about 29. Shell costs £36.23 a share, nearly ten times as much, and is on a P/E of about 10.

So the £36 share is the cheap one and the £3.72 share is the dear one — the opposite of what the share prices alone would suggest.

There's a second way to read it that I find more useful:

Flip it over. One divided by 10 is 10%: that's Shell's profit as a percentage of what you paid for it. You could think of it a bit like the interest rate on a savings account. M&S's is 3.4%. Why would anyone accept 3.4% from M&S when Shell offers 10% and Bank Rate is 3.75%? That doesn’t make sense…

There is a reason: because a company's profits can grow, and a bank's interest can't. People pay a high P/E when they expect the profit to be much bigger in time. A higher P/E ratio means the market expects the profits to grow more.

Which brings me to the whole American market. The S&P 500 is on a P/E of about 26 against a long-run average of about 16, and I know some of you will read that as a warning. It isn't.

The index has been above its long-run average P/E on the first day of every year since 2013, and it's now more than five times higher than it was then. A P/E is a tool for comparing one business with another. It's not a tool for deciding when to buy the whole market — that is something that cannot reliably be timed as I’ve shown elsewhere.

"A £5 share is cheaper than a £500 share."

It isn't cheaper, it's just smaller. A company decides how many slices to cut itself into, and the price of one slice depends on that as much as on anything the business does. Over time, the share price of a successful company keeps getting bigger and bigger, and over a long period this makes the share price unwieldy, so a company will often split its shares into a larger number of shares at a lower value — the same total value, lower individual value.

Berkshire Hathaway has never split its A shares, which is why one costs more than the average British house. Apple has split its shares five times, which is why one costs $337.

If a business is worth £10 billion, it's worth £10 billion whether that's one billion shares at £10 or ten billion at £1. The P/E ratio is the same either way.

Earnings per share — a company's profit for the year divided by the number of shares it has. It's the "E" in P/E, and it's the number that matters more than the price. Shell made about £3.45 per share last year; M&S made about 13p. When a company says its earnings per share rose 15%, that's the growth in your slice of the profit, and over time it's what drags the share price along behind it.

Book of the week: A Random Walk Down Wall Street, by Burton Malkiel. I first read this book in the 80s and it’s an essential read. Malkiel goes through every way people try to beat the market — charts, tips, star managers, the lot — and shows with the numbers why none of it works for long. It's also where the line about a blindfolded monkey throwing darts at the share pages came from, and the monkey has been holding its own for fifty years. Once you've read it you stop feeling like you're missing something. Get it on Amazon.

Know someone who thinks a 20p share is a bargain? Forward this to them.

See you next week.

Tim

I am not a financial adviser. Nothing here is personal financial advice. Please do your own research before making any investment decisions.