Understanding the P-E Ratio

There are basically two ways to value stocks: (1) By the calculation of an “intrinsic value” (that is, a proper, fair, or correct price for the stock); and (2) valuation ratios.

Intrinsic value calculations have been used at least since Benjamin Graham and David Dodd’s classic book, Security Analysis (1934). Nowadays, they are almost always based on discounted cash flow analysis, which incorporates scores of assumptions about the company, its “cost of capital,” and likely future events to arrive at a fair price for the stock.

In contrast, valuation ratios are simple mathematical ratios that divide the price of the stock by any number drawn from the company’s operations: its sales, earnings, book value, and so on. The valuation of the stock takes place by comparing each valuation ratio to historical norms for that ratio and/or to the ratios of other companies in the same industry.

The granddaddy of all valuation ratios is the P/E ratio, or price-to-earnings ratio. It is the stock’s price (P) divided by the company’s earnings (E). As with other valuation ratios, it provides insight into investor sentiment, because it tells you how much investors are paying to own a piece of a company that is earning X dollars per share. So, for example, if a stock has a P/E of 20, investors are paying $20 for each $1 in earnings per share of the company. (Investors pay more than one-to-one, because they expect the company to produce growing earnings in the future, and they are betting that the future earnings will translate into a higher stock price than what they are paying today.)

The P/E ratio is so universally used that its nickname is simply “the multiple.” It is by far the most common way of expressing a stock’s valuation, and it is a powerful indicator of market opinion about a stock.

Several variations of the P/E ratio exist. Investors should be careful that they are comparing apples to apples when comparing P/E ratios. Here are the two most common variations:

o Trailing P/E: This is the most prevalent P/E ratio. It uses the company’s most recent 12 months reported earnings for E, hence the name “trailing.” This has the advantage of using officially reported numbers (so there are no estimates), but the disadvantage that it is “old news.” (Companies report earnings quarterly, so the earnings number E could be three months old.)

o Forward P/E: This uses the company’s current fiscal year earnings for E. At the beginning of the fiscal year, the denominator E is entirely based on analysts’ estimates of earnings for the coming year. As the year progresses, quarterly actuals are plugged in to replace estimates, so the P/E becomes more real but also begins to age. By the end of the fiscal year, the forward P/E equals the trailing P/E and gets discarded, and a new forward P/E based entirely on estimates is created again.

Both trailing and forward P/E’s are widely available online and in newspaper stock tables. The P/E ratio does not have units: It does not have a dollar sign in front of it nor a percentage sign after it. It is a simple ratio, a plain number.

Once one knows a stock’s P/E, how does that translate into a valuation? By comparing it to (1) historical market averages, (2) current market averages, (3) historical P/E values for that company, and (4) current P/E values for companies in the same industry. Here are some general guidelines:

o A high P/E ratio reflects market confidence that the company’s earnings are likely to grow in the future. All else equal, the higher the P/E ratio, the greater the market’s confidence that the company will post high earnings growth rates.

o Lower P/E ratios reflect less confidence (or more uncertainty) in expected future earnings growth.

Speaking broadly, since the Great Depression the trailing P/E ratio of the market as a whole has averaged about 17. In the past decade or two, that number has inched upwards towards 20 (mostly because of the tech/telecom boom of the late 1990’s, when all P/E ratios trended upwards).

The forward P/E for the market as a whole is generally 5% to 10% less than the trailing P/E ratio, reflecting the average growth per year in company earnings. Thus the long-term historical forward P/E would be about 16 (compared to 17 for the trailing P/E), and the one covering the last couple decades would be 19 (compared to 20 for the trailing).

Let’s look at a specific example. (All of the following values are from Morningstar’s Web site.) As of this writing, Microsoft’s trailing P/E is 20 and its forward P/E is 15. The market’s respective numbers (using the S&P 500 as “the market”) are 20 and 16. Thus Microsoft is valued, by the “wisdom of the crowd,” at about average on its trailing P/E, but well below average on its forward P/E. Microsoft’s forward P/E of 15 is 21% below the market’s value of 19.

Let’s look within Microsoft’s industry, which is applications software. The market has assigned a trailing P/E to the industry of 26 (Microsoft’s is 20) and a forward P/E of 16 (Microsoft’s is 15). Again, considering especially the trailing P/E, which is just 77% of the industry’s, Microsoft’s valuation looks “low.”

What might we conclude from the above? One conclusion would be that Microsoft is somewhat undervalued by the market right now. That could mean that Microsoft is trading at a bargain price compared to its future potential. Another conclusion is not so kind to Microsoft: That market participants don’t believe very strongly in Microsoft’s potential going forward. That’s why they are valuing its stock less than the market’s and less than other players in its industry.

As a general rule, you want to find companies that will produce high, sustainable, and predictable earnings growth, but whose stocks are trading at bargain prices (that is, at low valuations). Microsoft’s valuation looks somewhat low. Is that because the market justifiably has concluded that Microsoft is going to be very challenged to produce high and sustainable growth rates, or is the market making a mistake on that point?

Before deciding whether to buy Microsoft, you must be able to answer that question. Does the market have it right (Microsoft is fairly priced compared to its future earnings) or wrong (Microsoft is a bargain at its current price)? Further research is required. The further research must include investigations into Microsoft’s likely future earnings growth rates, as suggested by its business potential, new products in its pipeline, recent earnings trends, and its ability to stave off competitors. One would also want to look at Microsoft’s other valuation ratios to see whether they too suggest that the company is undervalued at its current price.

Source by David Van Knapp

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