First of all, what is P/E? P/E stands for price-earnings. A P/E ratio is used to judge the value of a stock. It is calculated by dividing the share price with earnings per share. In its simplest and crudest interpretation, a low P/E ratio means that the stock is cheap and vice versa.
The following definition is quoted from Investopedia:
“The price-earnings ratio (P/E ratio) is the ratio for valuing a company that measures its current share price relative to its per-share earnings. The price-earnings ratio is also sometimes known as the price multiple or the earnings multiple.
(Investopedia Definition Link)”
Historical P/E ratio of Malaysia market
Why do I want to show you the P/E ratio of the market? What does the past have to do with the present and future? Because only by looking at the past, we can get a glimpse at what the future holds. I am not saying that the history will definitely repeat itself but at least, we have some data as a guide.
So after some googling, I found the following data from CEIC Data website (Link). It states that Malaysia’s FTSE Composite Index reached an all-time high of 21.03 in Jan 2010 and a record low of 13.22 in Sep 2011. The data was collected since 2009. The ratio is claimed to be provided monthly by Bursa Malaysia. Nonetheless, I could not get the data from Bursa Malaysia website. Not sure if there is some hidden link though.
Back to the main point, the historical P/E ratio ranges from 13.22 to 21.03. How were these values calculated? First, this P/E ratio does not take into account all companies in Bursa Malaysia. Instead, it uses FTSE Bursa Malaysia KLCI Index – Kuala Lumpur Composite Index (FBMKLCI) to represent the Malaysia market. This index includes 30 companies with largest market capitalization in Bursa Malaysia. What does this mean? It means that this ratio might not represent the whole Malaysian market. However, this is the closest data that we could get our hands on.
The P/E ratio range means that stock market as a whole is cheapest when P/E ratio is around 13 while it is most expensive when the ratio is around 21. Normally, the market P/E ratio fluctuates within 13 to 21. From this information, I would surmise that the market is fairly valued when P/E is around 17 (average of 13 and 21). How do we make use of this information?
Application
Let’s say we are evaluating a company and its share is selling at a P/E ratio of 12. Based on the data above, it can be considered as cheap (because P/E ratio is less than 17). So we should buy the stock now, right? No. Remember that the P/E ratio from CEIC is for the market as a whole (and honestly should only be valid for the 30 companies in FBMKLCI). Before we invest in a stock, we should look at its own P/E ratio throughout the years. Let’s say for the abovementioned stock, it ranges from 6 to 9 for the last 5 years. Will you still think it is cheap now?
Nevertheless, we should never use P/E ratio alone as the sole determinant of a trading decision. A low P/E ratio does not necessarily mean that it is a cheap stock. Some stocks are cheap because their fundamentals are bad. In a similar vein, we cannot classify all stocks with high P/E ratio as expensive. Sometimes it can be due to the fact that the company has a high growth potential and it might give you tremendous returns.
In conclusion, P/E ratio helps to evaluate the value of a stock but remember this is not a magic ratio in our investing journey.