P/E is short for the ratio of a company's share price to its
per-share earnings. As the name implies, to calculate the P/E, you simply take
the current stock price of a company and divide by its earnings per share
(EPS):
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P/E Ratio =
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Market Value per Share
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Earnings per Share (EPS)
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Most of the time, the P/E is calculated using EPS from the last four
quarters. This is also known as the trailing P/E. However, occasionally the EPS
figure comes from estimated earnings expected over the next four quarters. This
is known as the leading or projected P/E. A third variation that is also
sometimes seen uses the EPS of the past two quarters and estimates of the next
two quarters.
There isn't a huge difference between these variations. But it is
important to realize that in the first calculation, you are using actual
historical data. The other two calculations are based on analyst estimates that
are not always perfect or precise.
Companies that aren't profitable, and consequently have a negative EPS,
pose a challenge when it comes to calculating their P/E. Opinions vary on how
to deal with this. Some say there is a negative P/E, others give a P/E of 0,
while most just say the P/E doesn't exist.
Historically, the average P/E ratio in the market has been around
15-25. This fluctuates significantly depending on economic conditions. The P/E
can also vary widely between different companies and industries.
Using The P/E Ratio
Theoretically, a stock's P/E tells us
how much investors are willing to pay per dollar of earnings. For this
reason it's also called the "multiple" of a stock. In other words, a P/E
ratio of 20 suggests that investors in the stock are willing to pay $20
for every $1 of earnings that the company generates. However, this is a
far too simplistic way of viewing the P/E because it fails to take into
account the company's growth prospects.
Growth of Earnings
Although
the EPS figure in the P/E is usually based on earnings from the last
four quarters, the P/E is more than a measure of a company's past
performance. It also takes into account market expectations for a
company's growth. Remember, stock prices reflect what investors think a
company will be worth. Future growth is already accounted for in the
stock price. As a result, a better way of interpreting the P/E ratio is
as a reflection of the market's optimism concerning a company's growth
prospects.
If a company has a P/E higher than the market or
industry average, this means that the market is expecting big things
over the next few months or years. A company with a high P/E ratio will
eventually have to live up to the high rating by substantially
increasing its earnings, or the stock price will need to drop.
A
good example is Microsoft. Several years ago, when it was growing by
leaps and bounds, and its P/E ratio was over 100. Today, Microsoft is
one of the largest companies in the world, so its revenues and earnings
can't maintain the same growth as before. As a result, its P/E had
dropped to 43 by June 2002. This reduction in the P/E ratio is a common
occurrence as high-growth startups solidify their reputations and turn
into blue chips.
Cheap or Expensive?
The
P/E ratio is a much better indicator of the value of a stock than the
market price alone. For example, all things being equal, a $10 stock
with a P/E of 75 is much more "expensive" than a $100 stock with a P/E
of 20. That being said, there are limits to this form of analysis - you
can't just compare the P/Es of two different companies to determine
which is a better value.
It's difficult to determine whether a particular P/E is high or low without taking into account two main factors:
1. Company growth rates
- How fast has the company been growing in the past, and are these
rates expected to increase, or at least continue, in the future?
Something isn't right if a company has only grown at 5% in the past and
still has a stratospheric P/E. If projected growth rates don't justify
the P/E, then a stock might be overpriced. In this situation, all you
have to do is calculate the P/E using projected EPS.
2. Industry
- It is only useful to compare companies if they are in the same
industry. For example, utilities typically have low multiples because
they are low growth, stable industries. In contrast, the technology
industry is characterized by phenomenal growth rates and constant
change. Comparing a tech company to a utility is useless. You should
only compare high-growth companies to others in the same industry, or to
the industry average.
Problems With The P/E
So far we've learned that in the right
circumstances, the P/E ratio can help us determine whether a company is
over- or under-valued. But P/E analysis is only valid in certain
circumstances and it has its pitfalls. Some factors that can undermine
the usefulness of the P/E ratio include:
Accounting
Earnings
is an accounting figure that includes non-cash items. Furthermore, the
guidelines for determining earnings are governed by accounting rules (Generally Accepted Accounting Principles
(GAAP)) that change over time and are different in each country. To
complicate matters, EPS can be twisted, prodded and squeezed into
various numbers depending on how you do the books. The result is that
we often don't know whether we are comparing the same figures, or apples
to oranges.
Inflation
In times of high inflation, inventory and depreciation
costs tend to be understated because the replacement costs of goods and
equipment rise with the general level of prices. Thus, P/E ratios tend
to be lower during times of high inflation because the market sees
earnings as artificially distorted upwards. As with all ratios, it's
more valuable to look at the P/E over time in order to determine the
trend. Inflation makes this difficult, as past information is less
useful today.
Many Interpretations
A low
P/E ratio does not necessarily mean that a company is undervalued.
Rather, it could mean that the market believes the company is headed for
trouble in the near future. Stocks that go down usually do so for a
reason. It may be that a company has warned that earnings will come in
lower than expected. This wouldn't be reflected in a trailing P/E ratio
until earnings are actually released, during which time the company
might look undervalued.
