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Fundamental Analysis: Price-earning ratio and its variants

Price-Earning (PE) ratio is the ratio of market price of the stock compared to the earnings per share. It shows the sum of money you are ready to pay for each dollar worth of earnings of the company. Its formula is

PE = Market Value per Share / Earning per Share (EPS)

DIFFERENT VERSIONS OF PE RATIOS

Trailing PE

When Earnings per share is taken from the last 12 months results , the resulting PE is called trailing PE. Trailing PE captures what is already done and happened. Its most popular because of its objectivity.

Forward PE

Forward PE uses the estimated future earnings of the company instead of the trailing figures. It is handful in comparing present earnings and future earnings .It is helpful in predicting what earnings look like in absence of one off charges and accounting adjustments.

Personally I am not a great fan of Forward PE because it can be fraught with folly. The earnings estimate can go wrong for so many reasons and the whole analysis can get wrong. Moreover with trailing EPS you are dealing with facts and realistic figures.

The PE ratio is one of the most popular metrics for determining the value of the company .Both trailing and forward PE are great indicators but each has its disadvantages. Its best to use them together to further your research.

Graph (1)

Disclaimer: The above Graph and figures has been taken from Robert Shiller and his book Irrational Exuberance

The graph above shows the historic S&P 500 PE ratio spanning more than 130 years

Current S&P 500 PE ratio is 25.88(Updated on 28 th Dec’2016)

Mean:15.63

Median: 14.64

Min: 5.31 (DEC’1917)

Max: 123.73 (MAY’2009)

Significance of PE ratios

Price to earning ratio indicates how cheap or expensive a stock is. If PE ratio of a stock is 10, than it tells us that investors are willing to pay 10 times of a company’s earnings to buy that stock.

Stocks with PE ratio less than 10 are often considered as cheap. It may mean a bargain and a buying opportunity. High Price to Earnings ratio indicates investors are expecting high earning growth in future .But PE alone cannot be considered as a standalone metric to consider an investment.

If all other things remain same, then $500 stock with a PE of 12 is cheaper than $10 dollar stock with a PE of 20.

Companies that don’t have any profit or negative earnings do not have a PE ratio. To evaluate such investments other valuation metrics are used.

How to use Price to Earnings ratio before investing?

When we are evaluating Price per Earnings of the stock we have to take into account the average PE ratios of peers in the same sector. Normally stocks from some sectors like IT have high growth rate and they get higher PE multiple. Similarly commodity based companies in mining and metals get a low PE .You cannot compare the PE of a stock across the industries because of inherently different business structure.

You have to take the median PE of a stock over a period of time. Ideally I look at last 10 years of data to arrive at the median PE. PE ratios within a short period of time can be misleading.

In order to ascertain the valuation of stock its PE has to be looked along with Price/Book value ratio as well as Debt/Equity ratio.

Drawbacks of Using PE ratios

Sometimes the company can report one off gains or one off losses which affect the earnings of the company. There can be some other accounting adjustments which can distort the earnings. In such cases PE has to be critically examined with other metrics and facts.

High Inflation can eat Company’s earnings .This in turn can return high PE ratio of the stock which is more a reflection of increased costs rather than high growth potential of the stock.

Trailing PE ratios talk about the past earnings. It is difficult to evaluate future growth prospects using this ratio.

There is no doubt that PE ratio is the most popular valuation metric used in stock investment analysis. However as we have seen it has its drawbacks. In order to overcome those drawbacks it has to be used with other metrics like Price/Earnings to Growth (PEG) ratio and earnings growth which helps in building a complete picture.


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