Price to Earnings Multiple in Context of Stock Market Investments

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Many Stock Traders today are using PE Multiples for different reasons.

I have seen the greatest abuse and misuse of such ratios as a risk manager in the financial sector.  I had way too many arguments with Dumbo Non-Technical Traders who just buy and sell using such relative valuation ratios.  Some of the dealer blokes weren’t regrettably even able to distinguish between Trailing and Leading P/E Multiples.

So I thought that it would be useful to share my perceptions about the Price to Earnings Multiple with my followers and those who have an applied and/or academic interest in the subject of Financial Markets and Investment Risk Management.

so what is a P/E Multiple?

  • Price Risk Hedging Tool ?
  • Stock Market Investing Tool?
  • Market Signalling Tool?
  • Financial Valuation Tool?
  • Intra-Day Trading Tool ?
  • just another Academic Ratio ?
  • or all of the above ?

In my opinion P/E Multiple has all the aforementioned characteristics.

Let me clear this misconception that Price to Earnings Ratio / Multiples are just a trader specific investing tool!

They are even used by  “Risk Managers” to evaluate Market Timing of Trades, Alpha Risk and also keep a further check on Valuation Specific (Model) Operational Risks!! 

Well should I go on ? give you a few examples.

Okay 😉 try the one shown below:

  • A fund manager buys stocks which are way above fair value! Is this a risk ?
  • A fund manager sells stocks which are way below fair value! Is this a risk ? 
  • how can P/E Multiples be utilized to control  such irrational trading decisions?

well the risk manager should study the fair value of stocks using either the SML – Security Market Line or a Leading Price to Earnings Ratio (multiple).

In my opinion buying  overvalued and / or  selling undervalued stocks can pose both Valuation Hedge  and Short Fall Risks accordingly.  

This very well may also translate itself into Market timing risk i.e. buying or selling at the wrong time, by ignoring the equilibrium (intrinsic) values of an equity security!!

Hence the P/E Multiple has a pivotal role, which can be used to judge how risky a “stock bet” may be and / or how expensive or cheap an actual  trade execution turns out to be at a certain point in time.

  • How to calculate a Leading Price to Earnings Multiple ?

                 Price per Share / Forward Earnings Per Share

  • How to calculate a Trailing Price to Earnings Multiple?

                Price per Share / Last reported Earnings Per Share

Can their be a `one size fits all` P/E Multiple application?

Ans: NO!!!

why ? =>

  • P/E Multiples are interpreted in a different way for different types of stocks( Penny, Recovery , Cyclical, Blue-Chip, Seasonal, Defensive, Growth, Momentum and other Equity categories).
  • P/E Multiples don’t always work in emerging markets. Because => Markets are not always  information and / or valuation efficient.  I am NOT going to do a debate on EMH – Efficient Market Hypothesis Theory in this blog.
  • P/E Multiples can have a different meaning in altogether if “trading markets” are proven to be Markovian (Non-Markovian), Random Walking or Mean Reverting in nature. This requires lots of more research and analyses.

Hope this explains to you as to how and why Price to Earnings Multiple/s can be both useful and harmful in practical life of a trader !!

A wrong use may lead to a bad investment decision and vice-versa.

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About sahriskmanager

I have worked as a Head of Risk and a risk culture builder at both Asset Management and Commercial Banking Institutions within and outside of Pakistan. Over the years I have developed exhaustive understanding of risks that exist in both Sharia and Conventional Finance related Investments and Financing/Lending Products. I have invaluable experiences to share with respect to setting up and restructuring of Financial Risk Management Departments at Islamic Banks and Asset Management Firms . This includes developing policy and procedure manuals, recruiting of staff, imparting Risk Trainings and preparing the entire SDI (System, Design & Installation) work-flow frameworks for the department itself. What I shall post on these blog pages are my personal experiences, global risk management issues and academic interests which I would like to share with academicians, students and practitioners of FRM - Financial Risk Management all over the world.
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