Back to the Basics: Price-Earnings Ratio (P/E Ratio)

Filed under: Archived Articles,Articles |

Back to the Basics: Price-Earnings Ratio (P/E Ratio)

Why You Should Take a Look at Multiple PE Ratios When Evaluating a Stock

Considered by many investors as a “quick” way to value a stock, the Price-Earnings Ratio can be a key valuation metric to making informed stock investment decisions. And, the price to earnings ratio [P/E Ratio] is one metric that has more to it than meets the eye.

What is a Price-Earnings Ratio (P/E Ratio)?

Plain and simple, the P/E Ratio for a stock is calculated from its current market price per share [P] in relation to the stock’s earnings per share [EPS]. Below is a look at the PE Ratio formula.

peratio

Generally, the market looks at high P/E Ratios as growth stocks and low P/E Ratios as value oriented stocks. The P/E Ratio is basically showing what the shares are worth compared to the company’s past earnings.

While a stock’s current market price is universally available on sites like Yahoo Finance http://finance.yahoo.com/ you may come across some inconsistencies with the EPS. Why is that?

Well, “…investors routinely debate if the price of a company is the current reflection of its value, [and] everybody agrees that the price represents what an investor will pay for the stock right now.” [1] Price is what we see on the ticker—but the EPS is not as consistent.

So, if we really want to understand a stock’s P/E Ratio, then we should at least know something about its EPS—more specifically what’s going on with its consistency.

Clearing the Air on EPS

There are essentially two types of EPS:

1. A Company’s Past 12 Months Earnings per Share Performance

2. A Company’s Projected Earnings—[often] found in the Quarterly Report, Annual Report or in a recent press release

The past 12 months performance report is public record—and you can generally take this as the “gospel”—because that’s what the company reported to the SEC. And very few companies want to be lying to the boys with the alphabet behind their names. This type of EPS is often time referred to with a tag ‘trailing 12 months’ [ttm].

The second EPS that can also be useful comes from details in the company’s earnings release or analyst’s calculations. This is only a projection of what the company believes it will be earning in the future based upon the present market—do not take this as absolute fact, but rather “the company’s best educated guess.” [1] A great source of information, no doubt, but just note there is always the risk of inflated self-reporting and miscalculations… intentional or unintentional.

P/E Ratio—A Multi-Tool for Informed Investors

The different calculations for EPS allow for the P/E Ratio to have multiple applications: Trailing P/E, Forward P/E, and then there’s the PEG Ratio which we’ll talk about in jast a few minutes. Through Trailing P/E, investors can analyze a stock’s current price in light of its past earnings performance. Arguably, Trailing P/E is the most ‘objective,’[1] but you are working with past data.

Many investors look at the Trailing P/E and consider it “THE” P/E Ratio because there is less room for skepticism [this is of course assuming the company had reported accurate numbers].

Additionally, this ratio doesn’t rely on earnings estimates (either company reported or third-party analyst generated) —what you see is what you get. Also, remember to compare the company’s P/E Ratio with its peers and industry. In isolation, it doesn’t do you much good to compare a P/E for a mining company against one in the bio-tech sector.

No doubt, this is the most popular and most widely reported metric, but it is not without its drawbacks. To assume the future worth of a company’s stock based on the results of the past 12 months isn’t 100 percent. It is because of this that we may find the Forward P/E Ratio useful.

With a Forward P/E [or Estimated P/E], you are analyzing current company earnings and comparing it to potential/future earnings. This may be useful for projecting the future, but one must take into account any ulterior motives a company may have to reporting what it’s reporting.

For instance, “a company may conservatively or purposefully underestimate its earnings to beat the street’s expectations” [1]—this would make the company look good come reporting time. Another instance you may have a company knowingly inflate the reported earnings.

Not exactly ethical behavior, but it does occur, so be mindful of that possibility. It is recommended that if you are to lean on this P/E metric that you keep up to date with company news and do some regular research. Like the Trailing P/E, the Forward P/E is not without its faults.

And now we come to the PEG Ratio [Price/Earnings to Growth]

The PEG boiled down is a stock’s P/E Ratio divided by its projected growth, expressed as Annual EPS Growth. The calculation for the annual growth rate can be forward (predicted growth) or trailing, and can be a one to five year time span. Make sure you know which one is being used. [2]

OK…what PEG number are we looking for?

I wish it was as simple as… a lower ratio means it is better (a cheaper stock) and a higher number means it is worse (expensive)… but guess what??? It doesn’t work quite that way.

While we may be looking for a number hovering around “1.0” which generally indicates a reasonable tradeoff between cost (as represented by the P/E Ratio) and growth…a number higher than 2.0 and we probably have an expensive stock on our hands.

Much lower than 1.0 and we have could have a “cheap” stock that’s truly undervalued and represents a great opportunity or one that the market thinks might not live up to expectations. (Source: Yahoo.com).

Like the two metrics that came before it, the PEG is a very useful ratio you ought to know; but do not use this as the sole indicator to buy or sell, just make it one more tool in your tool box, albeit it a very useful tool.

The Price-Earnings Ratio (P/E Ratio) in Action

All this talk about the P/E Ratio and we’ve yet to give an example with some hard numbers. Let’s fix that and put the P/E Ratio to the test.

If a stock’s price is $10 per share and the EPS of the last 12 months is $2, then the stock’s P/E [ttm—trailing twelve months*] would be 5. Five is not a high P/E at all [*Rule of thumb: A high P/E means that the market believes the stock could grow more quickly]. Or… conversely, it could also indicate an over-bought condition that’s primed for a correction. It depends.

It is not uncommon to see a P/E in the teens, twenties, thirties or even 50+. If we alter our measurements a little bit, we see a different story—let’s consider a stock priced at $50 per share and a past 12-months EPS of $1.50 per share; we are now looking at a P/E of 33.3. As mentioned, the higher the P/E, the higher the expected growth is…right? Depends.

Getting a Better Look with the PEG [2]

Say you are interested in buying stock in one of two companies. The first is a networking company with 20% annual growth in net income and a P/E Ratio of 50 (indicating a higher growth rate). The second company is in the beer brewing business. It has lower earnings growth at 10% and its P/E Ratio is also relatively low at 15 (indicating the market may not think as highly of it as the networking stock).

Many investors justify the higher stock valuations (higher P/Es) of tech companies by relying on the assumption that these companies have enormous growth potential. They may be right, but are they in this example?

This is where the PEG Ratio comes into play.

Networking Company:

Beer Company:

The PEG Ratio shows us that, when compared to the beer company, the always-popular tech company doesn’t have the growth rate to justify its higher P/E, and its stock price appears overvalued. Now, you might be able to make a more informed decision about which stock you want to stick in your portfolio.
The PEG tells the story [2]

Subjecting the traditional P/E Ratio to the impact of future earnings growth produces the more informative PEG Ratio. The PEG Ratio provides more insight about a stock’s current valuation. By providing a forward-looking perspective, the PEG is a valuable evaluative tool for investors attempting to discern a stock’s future prospects.

Calling a Spade a Spade

OK… so there are the basics; you have a few formulas to work with and a few ins and outs in regards to P/E Ratio. The key point to remember though is this—all the metrics in the world are simply tools; nothing is for certain when trying to project the future of the market and more specifically the price potential of a given stock.

The P/E Ratio, with all its worth and value, is a great metric [in its several variations], but that’s it. The PEG Ratio seems to be a more informative metric and one that more investors should use.

The stock market is basically a crapshoot for the uninformed; hopefully you now have a few more weapons in your arsenal to try to make an informed decision and tilt the odds in your favor.

Here’s to being as prepared as you can be.

Sources & References

1. Parker, Tim. (April 10, 2013). Differences Between Forward P/E and Trailing P/E. Investopedia.com.

a. http://www.investopedia.com/articles/investing/041013/differences-between-forward-pe-and-trailing-pe.asp

2. Investopedia Staff. (Feb 07, 2011). How To Use The P/E Ratio And PEG To Tell A Stock’s Future. Investopedia.com

a. http://www.investopedia.com/articles/00/092200.asp

- http://upload.wikimedia.org/math/a/5/5/a55b6c45db556f8923226fb226d2d3ac.png

- http://blogs.cfainstitute.org/insideinvesting/2012/08/16/is-it-overvalued-look-at-the-peg-ratio/

- http://www.fool.com/investing/value/2006/04/06/how-useful-is-the-peg-ratio.aspx

Posted by:

clip_image003

Mike Casson
Executive Editor
Follow me on Twitter

NOTICE: MicroCap MarketPlace (MCMP) is a financial publisher and not a broker/dealer or investment adviser. Readers, subscribers and web site visitors are responsible for individual investment decisions. All information contained in our newsletters or on our web site should be independently verified and readers should always conduct their own research and due diligence and engage professional advisors as they deem appropriate before making investment decisions. Past results are not necessarily indicative of future performance.