In the last episode, the concept of earnings have been discussed and how income streams create value. Once the value of an income stream has been defined, it can be compares to price. This is done using a price-earnings ratio.
How to calculate a price earnings ratio
The formula for price earnings ratio is,
In words this is the price of the share in the market, i.e. the price you pay on a stock exchange divided by its earnings per share (EPS). To understand EPS, please go read the previous article here.
What does the ratio mean?
The ratio is extremely easy to interpret and use, but let us look at an example. If we found in the last article that after all mining expenses, the net income in a year is 0.5 Ether. Currently the market price of ETH is around $300. Then the net income is $150.If we apply the above formula we would then get,
This means that for every $2 dollars we pay, we will get $1 in return. Or in short we would get all our money back in 2 years!!
How the PE ratio helps determine if something is expensive or cheap.
In general the PE ratio differs widely by industries, with ratios only comparable within industry classes. There are some stocks like Amazon with a PE ratio of 200 and most other stocks with a PE of between 10 and 20. Amazon is an exception because it does not pay out all its income as dividends, but tends to reinvest. There is no reinvestment in crypto, unless you use the profits to upgrade your equipment. Companies and crypto can have a high P/E ratio in its growth phase but it can only capture so much market, when it stops capturing more market share, it needs to start paying earnings. This very high PE indicates high future growth of earnings. In general a low PE is preferable for mature cryptos and a higher PE for young cryptos, but if the PE is too high, for example higher than Amazon, you may need to review its future prospects.PE shortfall
The only real shortfall is that it does not capture capital growth and should be used together with other ratios.There are other shortfalls,
- It is a single number and does not capture everything of a company
- Does not look at future potential of a company / crypto
- Ignores measures of goodwill such as brands
- Future prospects and values fluctuate, and PE is a static measure at a point in time
But in general all ratios suffer from some of these drawbacks. That is why it is important to consider all of them together.
Till next time,
Tinus
** Images courtesy of Shutterstock and LateX Equation Editor