If you are a stock investor, PE Ratio is an important indicator to help you make better investment decisions. Especially in a volatile stock market, when you are overwhelmed with market noises, PE Ratio gives you a good idea if the market is overpriced or undervalued.

2018 is surely a tough year for stock investors, especially Singaporeans. The local stock market, represented by the Straits Times Index, has slumped more than 10% in the past 2 months.

You may have a lot of worries now. Is the trade tension between the US and China really bad for their stock markets? Will Italy trigger another Euro Debt Crisis? How will the rising interest rate affect your investment portfolio?

If you followed my blog for a while, you know some of my investment philosophies. I have explained to you why buy-and-hold strategy doesn’t work in today’s market and how investors could be trapped by a commonly believed index investing strategy.

Now you have 3 options

1. Do nothing and hope the market will recover
2. Buy more because you believe the stocks are oversold
3. Sell and get out of the market as you can’t bear it anymore

In this article, I want to introduce you a simple tool to help you make your investment decision: Price-Earning Ratio, a.k.a. PE Ratio.

What is Price-to-Earnings Ratio

PE ratio is one of the most widely used ratios in the stock market. You probably have heard about it before. But the financial world like to complicate things, this easy to use tool is often downplayed in an overwhelming market like now.

You can think about PE ratio in this way. if you open a café, you need to purchase a coffee machine to make coffee and sell it. If you use $10,000 to purchase a coffee machine (the price) and this machine generates $1,000 profits (the earnings) for you every year, your PE Ratio is $10,000/$1,000 = 10. It also means you will get back your investment capital in 10 years’ time.

Why is PE Ratio useful?

PE ratio gives you a quick idea if you are buying stocks at a good price.

We all want good deals. If you intend to buy an iPhone and you know there is a 20% discount promotion next week, would you buy it now or wait for another week? You probably will wait. This is because you got to enjoy the same benefits at a lower price.

If you can purchase the coffee machine at a discount, say $8,000, your PE ratio now is 8 which is a good thing for you. If the seller is asking $12,000 for the coffee machine, you may want to give it a miss and move to the next seller.

The same goes for the stock selection. If the PE is high, it warns of an over-priced stock. You want to buy stocks with low PE ratio.

Which level of PE Ratio is good?

To understand the PE Ratio of Singapore stock market, you can use SPDR Straits Times Index ETF as a proxy. It is an exchange-traded fund that tracks the performance of 30 blue-chip stocks listed in SGX, know as the Straits Times Index (STI)

According to SPDR’s website, the PE ratio of STI is 10.45 as 27 June 2018

To put this number into context. You can look at the historical PE ratio of STI index for the past 10 years. The chart below shows the average PE Ratio was around 12 and 10.45 at an attractive level now.

But low PE doesn’t mean the market won’t go lower. You can see that STI PE ratio was nearly 6 during the Global Financial Crisis.

More about PE Ratio

If you go a bit technical, there are different ways of calculating PE, it will not be on today’s topic. But you need to understand PE ratio is not only affected by price but earnings as well.

You may have bought your coffee making machine cheap, but if you can’t sell enough coffee in the coming years, it may not be a good investment either.

Most PE Ratios you see from the headline news are backward looking. For example, the PE ratio reported in SPDR’s website is calculated by dividing the stock price by the earnings of the last 12 months.

Since the last stock price is a known factor, it is the earnings that play a crucial role. That is why financial institutions spending millions of dollars on analysts trying to forecast a company’s next 12 months earnings.

PE Ratios are sector specific

PE ratio that is considered very high in certain sectors can be considered very low in other sectors. When you research your investment, you must know which sector you are referring to.

The PE ratio of the components of STI gives us a very good guide. From the table below, you can see some familiar names with very low PE now. For example, Capitaland’s PE is $8.37 and Singtel is $9.24.

At the same time, if you are holding stocks of those at the bottom of this table, you may reconsider your positions.

Is it a time to buy stocks now?

Your investment decision should follow your investment objectives.

Investing for income:  It could be a good time to accumulate some stocks with a higher dividend yield (due to the slump of the price). We won’t know if the current price level is the lowest, but PE ratio tells you that you are much safer compared to last year.

Investing for growth: The current market of STI is downtrend, period. A lower PE ratio doesn’t mean the market will revert to mean in a short term. You can see from the early chart that the market can stay below the average PE Ratio in 2 or 3 years.

At the end of the day, it is a matter of risk and reward.

Look at your investment portfolio holistically

Despite the recent market crash, my Global Momentum Compass portfolio was held up very well.

The reason is simple, a holistic approach and adapt the portfolio to the market.

You can find out more about my investment approach in this post.

I hope this article is beneficial to you. As always, feel free to ask any questions by commenting below.