What's in a P/E?

Critical to the process of stock selection irrespective of investment philosophy, is the identification of quality companies with attractive fundamental characteristics and a positive trading outlook. However, tilting the investment scale towards such issues without considering appropriate valuation criteria is clearly a blinkered approach.

Determining the value of a company is a crucial dimension to any stock-picking strategy and to this end various yardsticks have been employed by the investment community. Typical measures focus on cash flow, asset values, debt positions, returns on equity and dividend yield. However, the most widely used selection tool is the price earnings multiple, which is the ratio of a company's stock price to its earnings-per-share.

As a rule of thumb, the higher the P/E the more expensive the company is considered (although this often implies greater future earnings growth expectations). However, the ratio offers little insight when taken in isolation and consequently the more complicated task lies in its relative interpretation. For example, when focusing on the multiple of Barclays it is important to consider the corresponding multiple of other banks and of the market in general. Essentially, the key issue facing investors in deciding whether this is an appropriate multiple is the stock's relative ability to deliver good and secured returns over the long term.

While the P/E is not the final measure of a stock's attractiveness, taken in context, it should play an important role in any investor's toolkit, particularly for companies in relatively mature industries.