Price Ratio Analysis Explained: How Is It Important To Companies? ⚖️
Price ratio analysis or price-to-earnings ratio is a valuable concept for both investors and businesses alike that helps determine the relative values of shares. It is referred to as the direct relationship between the market prices of a company’s shares and its earnings. What exactly is price ratio analysis? How does it serve a purpose on the profitability of companies?
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Calculating the value of a company’s share is difficult and time-consuming. It is influenced by various factors, for one reason. These include the nature of the firm, the government’s economic regulations, the demand and supply of shares, the company’s net worth, earning capacity, growth potential, and so on. Trying to weigh all of these variables might be tricky. Then it should make good sense for both the investors and the business itself. To make the procedure easier, there are several methods for determining the relative worth of a share, one of which is price ratio analysis. Is it the best choice for your company? What are the advantages and disadvantages?
In this article, we’ll do an overview of the concept of price ratio analysis, its benefits and importance, as well as increasing profitability with the correct ratio. We argue that this valuation metric should be widely used by enterprises and investment organisations. Lastly, we’ll also be taking a look at the telecommunication industry as a case study example.
At Taylor Wells, we believe that all businesses and investors should have an easy way to ascertain the value of their shares. By the end, you will understand price ratio analysis and how to use it to increase trust among shareholders and executives, hence increasing the profitability of your business.
Price Ratio Analysis: Definition, Importance, & Case Study
The Concept and Definition of Price Ratio Analysis
Price ratio analysis or price-to-earnings ratio (P/E ratio) is a method to measure a company’s share price. This is relative to its per-share earnings. P/E ratios are also known as price multiples or earnings multiples best for financial forecasting.
These ratios are what analysts use to determine the relative values of company shares. It’s also one of the most important stock analysis tools that investors use to define stock valuation versus what a company earns. In other words, this tells investors the dollar value they need to invest to earn one dollar from company profits.
PE Ratio = Market Price Share/Earnings per Share
Why is Price Ratio Analysis Important?
Price ratio analysis gives investors a lot of conveniences. It is vital for investment strategies because it allows investors to determine the true value of the stock. The price ratio analysis can be used to assess the relative potential of a possible investment.
Price ratio analysis assists investors in verifying how much they should compensate for shares based on their current earnings, as well as examining whether the market is overvaluing or undervaluing the firm.
It facilitates forecasting earnings per share allowing investors to decide what a stock’s fair market value must be.
A high P/E ratio means investors expect to earn more in the future. A lower P/E might mean investors will earn less or undervalued the company. It can also indicate that it’s doing historically better than in previous years. If a company doesn’t earn anything or is posting losses, the price ratio is expressed as N/A or not applicable.
The median of a company’s P/E ratio over several years can be seen as a benchmark for its performance, indicating whether or not the company is worth investing in or if a stock is worth buying.
Limitations of Price Ratio Analysis
As with anything, price ratio analysis has its limitations. A single metric shouldn’t be used to determine whether a company is worth investing in or not. Using P/E ratios to compare companies in different sectors to each other can prove faulty. It’s because companies become profitable at different times.
That’s why price ratios are best used as a form of reference to compare companies in the same sector. Market trends differ too much between different industries for this ratio to be valuable across industries. Debt and leverage might also skew insights from P/E ratios.
One of the most notable limitations of price ratio analysis is that it provides shareholders with little information about the firm’s EPS growth prospects. Say, for example, if the company is rapidly expanding, investors might feel confident investing even if it has a high P/E ratio, knowing that EPS growth would then carry the P/E back down to a more reasonable level.
In contrast, when a business isn’t growing fast, investors might prefer a stock with a lower P/E ratio. It is frequently hard to determine whether a high P/E multiple is due to expected growth or if the stock is merely overvalued.
Therefore, a P/E ratio, even though measured using a forward profits approximate, is not an indication that the P/E is relevant to the company’s projected growth rate.
Let us now proceed with the telecommunication industry as a case study for the price ratio analysis.
Price Ratio Analysis in The Telecom Industry
The telecom sector is a good example of where evaluating P/E ratios can be beneficial. Telecom companies are high in growth. The use of price ratio analysis and P/E ratios indicate their growth potential. Though COVID-19 has given all industries problems, the telecom industry is not doing as bad.
Australian-owned and operated Central Telecoms have doubled the size of its customer base and increased its number of employees in 2020. They have plans to open up 40 new locations in the next two years. The company also received numerous awards for growth and ratings this year.
We’re seeing the same trends all around the world. Reports of telecom industries in Poland show rebounds in the last quarter of 2020 that project numbers will return to pre-pandemic performance in 2021. Telecommunication companies have taken defensive measures during the pandemic and expect to see positive impacts.
These are some examples of changes the industry is seeing due to the pandemic:
Positive Impact during the Pandemic on Telecom Companies
- Higher usage of mobile data due to increased purchases from individuals. This will cause increases in revenues for operators and services provided by smartphones.
- Remote work or work-from-home increases the need for company SIM cards, mitigating negative losses from other areas.
- There are higher volumes of social and business phone calls in mobile or fixed-line networks due to virtual meetings replacing in-person interactions.
- Increased call minutes due to lockdowns and quarantines preventing social interaction.
- Projected demand increases for value-added services.
- Increased demand for private VPN networks.
Read about Telstra’s global pricing objectives and strategies.
Read about how a Telco CEO structures his pricing department.
Telecom P/E Ratios – Are Low Ratios Bad?
Accelerated online presence and digital transformations are happening across most industries. This is an expected effect of travel restrictions, lockdowns, and remote working. Behavioural shifts toward e-commerce are also affecting how businesses operate, creating a surge in demand for telecom services.
Negative impacts and disruptions persist despite numerous positive effects. Communication Systems (JCS) and Wireless Telecom Group’s P/E ratio falls at zero at one point this year. Thus, telecom companies need to step up, respond to demand and new opportunities created by the pandemic. Boosts may be short-term and companies need to transform those opportunities into long-term growth.
However, low-zero P/E ratios don’t always mean a company is doing badly. It could be that stocks are at bargain prices. Tesla is a good example of a company with a low or zero P/E ratio since they pour their cash flow into massive expansions. This number is also in contrast to previous years when they’ve done better.
How To Increase Profitability Ratio
All companies can boost their profit margin. A single element can sometimes considerably raise profitability, but for most firms, increasing cash flows entails incrementally integrating a lot of improvements. How exactly can you increase your profits?
Profitability may be improved through four key sources of value. These include cost reduction, higher turnover, productivity gains, and increased efficiency. Some businesses also enter new market segments or create new products or services. Here are five stages that explain how to do it in detail:
1. Manage costs.
Find which processes in operation teams produce waste the most. There will always be ways to minimise this and discover how to put them to good use. Nevertheless, don’t cut costs in ways that reduce the quality of your products/services.
Reexamine your costs. What are your terms with suppliers? There may be ways to negotiate a better deal with them or find a new supplier if need be. Also, recheck your operational costs. How can you maximise office premises? Be careful not to compromise office environment quality though.
2. Expand to a new market.
With constantly changing customer needs, some problems help people solve using your products and services. For instance, just take a look at how the restaurant industry coped during the pandemic.
3. Reassess your price, marketing strategy, and customers.
Your pricing should be reviewed often. Price adjustments can be made based on competitors or customer demands. It’s important to determine which price changes will be temporary or permanent. Decide if you must lower or raise prices.
4. Who are your most profitable customers?
The Pareto principle suggests that 80% of consequences come from 20% of causes. This is also applicable to business operations. Are you targeting the right market? Identifying this needs research and evaluation. Take a look at how Nike achieves this.
5. Find cross-selling and upselling opportunities.
Most businesses achieve this by adding extra services or product features that competitors lack. Some brands that achieve this include Apple, McDonald’s, and those in the telecom industry.
Value-added services often show how much customers are willing to pay in exchange for great customer service. Of course, how you set the price and market these extra features play a huge role too. Take a look at how McDonald’s and the mobile phone industry do this.
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Bottomline
The takeaway from this is that using price ratios to analyse a company’s profitability can be very useful and insightful. Otherwise, there are many limitations and other factors you’ll want to consider to get the full picture of a company’s performance. P/E ratios are helpful for sectors like telecoms, but may not be the best metric to look at for disruptor companies like Tesla. Nonetheless, price ratio analysis is an important tool to understand to navigate the stock market and know how to increase your overall profitability ratio.
For a comprehensive view on maximising your companies margins,
Are you a business in need of help to align your pricing strategy, people, and operations to deliver an immediate impact on profit?
If so, please call (+61) 2 9000 1115.
You can also email us at team@taylorwells.com.au if you have any further questions.
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