The price-earnings ratio, or P/E ratio.
Widely used by investors when valuing a company, and in making decisions to buy or sell shares.
How to calculate the price-earnings ratio?
How do some investors use the P/E ratio?
And what are some of the reasons not to use it?
Let’s start off with the calculation of the P/E ratio.
The price-earnings ratio equals the share price of a publicly traded company divided
by its Earnings Per Share.
If a company’s share price is $50, and EPS is $5,
then its price-earnings ratio or P/E ratio is 10.
Finding the latest share price is easy, just look it up online for the company you want
to research.
But which Earnings Per Share number should you take?
Here you have a choice of historic actual numbers (“looking back”) or estimated
future numbers (“looking forward”).
Looking back, you can take the EPS of the company’s latest fiscal year, or if you
prefer more recent numbers take the TTM, trailing twelve months.
Here’s how trailing twelve months works.
If Q4 results just got published, take the EPS for Q1 through Q4.
If Q1 results just got published, take the EPS for Q2 through Q4 of last year, plus Q1
of this year, to get the latest full year basis.
If Q2 results just got published, take the EPS for Q3 and Q4 of last year, plus Q1 and
Q2 of this year.
If you prefer to look forward, take the estimate for the current fiscal year EPS, the estimate
of next year’s EPS, or even the estimate of EPS two years from now.
The essential question you are trying to answer when calculating the price-earnings ratio
is: How much are investors willing to pay per dollar of earnings?
Or in other words: how many years does it take to cover the price, if earnings stay
the same.
Let’s play around with that idea of the price-earnings ratio, and see how investors
might use it.
On the left: company A. On the right: company B.
These are very similar companies:
same industry, similar product, similar production facilities, similar go-to-market strategy,
and a lot more narrative starting with the word similar.
Company A’s share price is currently $36, and its latest reported Earnings Per Share $3.
Company A’s P/E ratio is therefore 36 divided by 3, which is 12.
Company B’s share price is currently $16, and its latest reported Earnings Per Share $2.
Company B’s P/E ratio is therefore 16 divided by 2, which is 8.
Investors that use price-earnings ratios for making investment decisions would probably
tell you that, given that company A and B are very similar, company A is overvalued
and company B is undervalued.
In their view, why pay more for the same thing?
Company B’s shares look like a bargain compared to those of company A. These investors would
sell shares in company A, and buy shares in company B.
If every single investor would use that rule, then the change in demand for the shares would
drive the share price of company A down and the share price of company B up, until the
share prices for both companies are in line with the average price-earnings ratio of 10.
A form of arbitrage selling.
Some investors go one step further.
Instead of comparing two companies and trying to determine which one is overvalued and which
one is undervalued, they might have an “absolute” rule of (for example) never paying more than
10 times the price-earnings ratio for a share, regardless of the industry a company is in,
and regardless of the stage in an economic cycle.
The management of company A obviously disagrees with that logic.
They believe there is a very strong reason for company A having a higher price-earnings
multiple: superior leadership, superior strategy, superior product, superior customer satisfaction,
and a lot more narrative starting with the word superior.
In a presentation to investors, company A presents a financial roadmap to get from the
current $3 earnings per share to $6 earnings per share in three years.
One of the stock market analysts in the audience makes a quick back-of-the-envelope calculation.
Assuming the same price-earnings ratios, the share price should rise proportionally to
the increased earnings.
If EPS doubles from $3 to $6, and P/E ratio stays the same, then share price should double
from $36 to $72.
This analyst would probably give a “buy” recommendation on the share.
$36 today for a share that could double in price in the next three years sounds like
a good bargain!
So much for the views of proponents of using the price-earnings ratio.
What are some of the reasons not to use it?
Companies go through various stages of development:
from embryonic to growing to mature to aging or declining.
Embryonic companies, in an early stage of development of both the company and its product,
have negative earnings per share, or possibly a very small positive earnings per share.
The price-earnings ratio for most embryonic companies cannot be calculated, as dividing
by a negative number or a very small positive number
would lead to P/E ratios that are not meaningful.
In my view, some of the most exciting investment opportunities
are exactly in that very early stage.
A second reason not to use the P/E ratio is that it is based on accounting profit.
Should we take the Earnings Per Share as reported, or the EPS from continued operations?
What about the effect of unusual items and changes in accounting rules on EPS, include
or exclude them?
The analysis becomes very subjective, it is not easy to standardize.
Once you go down this path, you start to “peel the onion”, which can have two effects:
either you get closer to the core, or you start crying, or both.
Reason number three for not using the P/E ratio is that in my view cash flow is far
more interesting than earnings or profit.
Show me the money!
Analyze the cash flow statement to determine how a company got from its cash balance at
the start of the year to the cash balance at the end of the year.
The numbers shown here as an example are for a mature company with strong cash generation
from operating activities, that can easily fund its capital expenditures as well as pay
a healthy dividend to investors.
A cash rich company with strong cash generation is a very different investment proposition
from its opposite!
Reason number four: the price-earnings ratio sounds attractive, but it can be very difficult
to define industries and find comparable peer companies.
Which product markets does a company serve?
What’s its financing structure (debt and equity)?
In which geographical regions does it operate?
Are we comparing apples to apples, or apples to oranges?
Here’s one more reason not to use the P/E ratio.
By the way, if you can think of any more reasons, please post them in a comment below.
The price-earnings ratio assumes stable earnings with very little volatility, and linear probably
upward development of EPS.
But is stability the right thing to expect?
The world is dynamic, not static.
You could even say that we live in a VUCA world!
A world that is volatile, uncertain, complex and ambiguous.
Companies that today might look stable and healthy, could suddenly decline in profitability,
or completely disappear from view in these disruptive times.
When investing in the stock market, beware of the unknown, especially the unknown unknown!
I hope you enjoyed this discussion of the price-earnings ratio, or P/E ratio.
A datapoint that many investors find very important, but in my view has severe limitations
in its usefulness.
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Thank you.