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The Mystery of Calculating a Target Price Earnings Ratio

The Price Earnings Ratio Defined

Understanding the P/E

Validity of of P/E as an indicator of value

Using the P/E Ratio to Select Stocks to Buy

Pitfalls in using the P/E ratio

The Price Earnings Ratio Defined

The Price Earnings Ratio ("P/E") is one of the key ratios that investors can use to assess the current price of a stock. The P/E is provided in newspaper stock price listings and in programs like YAHOO financial that track portfolios. 

But how is an investor to judge whether a P/E is good or bad? How can an investor calculate a target or "correct" P/E that a stock should trade at? 

Mathematically the P/E is the ratio of a stock's price to its (current or forecast) annual earnings per share. If a share is priced at $10.00 and earnings are at $1.00 per share per year then the P/E is $10/$1=10.

Understanding the P/E

One useful way to understand the P/E is to calculate its reciprocal, the earnings divided by the price ("E/P"). For a $10.00 stock with annual earnings of $1.00 this is $1/$10 = 0.10 or 10% . This indicates that the company is currently earning an amount per share equal to 10% of the price the investor must pay for the stock. Any P/E ratio can quickly be converted to an "E/P" yield by dividing the P/E into 100%. For example a P/E of 25 indicates a current earning yield of 100%/25 =4% .

The P/E also indicates the number of years it would take for the current level of earnings to "pay back" the amount being paid for the share. A $100.00 share with current earnings of $4.00 has a P/E of 25 and it would take 25 years of earning $4.00 to accumulate to the stock price of $100.

The P/E is the price that you must pay for each $1.00 of current earnings. If all other things were equal, investors would want to pay the same amount for each $1.00 of earnings from any source and all P/E ratios would tend to be equal. As usual though all other things are far from equal and various investments should and do exhibit vastly different P/E ratios.

Validity of of P/E as an indicator of value

The notion that a stock should trade at some multiple of its current annual earnings is really not very valid. Consider the following companies:

Company Year 1 EPS Market share price Calculated P/E Ratio Expected growth Forecast Year 2 EPS Forecast Year 10 EPS
Mature $1.00 $10.00 10 5% $1.05 $1.55
Start-up ($0.25) $10.00 Negative varies ($0.35) $5.00
High-tech $0.20 $10.00 50 35%   $2.98

The mature company has good earnings but is growing quite slowly. A P/E of about 10 might be expected.

The start-up is losing money but is expected to earn quite large profits in the future. since there is no earning, the P/E cannot be calculated. The stock market still assigns a positive value to the share because of its future potential.

The high-tech starts out with low earnings but is expecting very strong growth. The market might value this stock at a P/E of 50. 

The three companies could trade at vastly different P/E ratios due to the different expectations about future earnings. Different stocks should and do trade at quite different P/E ratios. Therefore, knowing the P/E of a stock tells you very little. Without further information, you absolutely cannot conclude that a stock with a P/E of 10 is a bargain compared to a stock with a P/E of 50.

The P/E is just a relationship between the stock price and its current earnings. The current P/E may or may not be justified by the earnings potential of the stock.

The P/E is useful if you can compare the current P/E to a target P/E that a stock with a given level of growth and risk should command. This is why it is useful to compare the P/E ratios of stocks in similar industries but it is not very useful to try to compare P/E ratios across industries.

 

Using the P/E Ratio to Select Stocks to Buy

The P/E ratio can be used in selecting stocks. But it requires an understanding of exactly why some stocks deserve a higher P/E ratio than others.

The current yield on government bonds is about 6%. A perpetual government bond would therefore pay out $6 per year for each $100 market value of the bond. The E/P is $6/$100 = 6% and the P/E is $100/$6 = 16.7. Note that earnings from the bond will remain constant, the growth rate is precisely zero.

A logical but wrong conclusion would be the following:

"A risk free government bond has a P/E of 16.7 and a current earnings yield of 6%. Therefore I shall buy stocks with a P/E below 16 which will then yield more than 6% and I shall shun all stocks with a P/E above 17."

However, the true value of a stock or bond cannot be calculated as a multiple of only the current year earnings. If that were true though, all stocks would trade at similar P/E values.

The true value of a stock must be based on the value of all expected future cash flows to the investor. 

The future cash flows are impacted by the expected current earnings, the dividend pay-out ratio, the expected growth rate in earnings and the risks that expected growth in earnings will not occur. If a liquidation of the company and the sale of its assets is a possibility, then the market value of its net assets might also determine the cash flows to an investor.

In addition the market interest rate and inflation expectations determine the present value of those expected future cash flows.

The P/E is available as an easily calculated reference number. However the P/E level of any investment can only be judged by making a complex adjustment for all of the factors that can impact the true value of the future cash flows to the investors.

Investment-picks has made available to you a table of calculations that mathematically illustrates the impact of the dividend policy, real interest rates, inflation, expected earnings growth and risk on the true value of a cash flow stream. A close study of our table will provide you with a better understanding of how these factors affect the appropriate level of the P/E. This table is available in our articles section.

We have provided a table of target P/Es that can be justified by a given growth level and dividend pay-out ratio. We have also provided an indication of how the P/E varies with interest rates, inflation and risk.

You can now look at the P/E of a company and then use our table to see the level of growth that would be required (in our opinion) to justify that P/E at various levels of risk. Then, consider whether a given stock has enough forecast growth and low enough risk to justify its current P/E.

Many investors might believe that a P/E of 30 is low for a growth stock. But most investors and investment advisors would not be able to provide the mathematical reasons why a P/E of 30 is justified. If you are interested in fundamentals and the math, investment-picks can help you understand exactly how much growth is needed to justify that P/E of 30.

 

Pitfalls in using the P/E ratio

The P/E is by no means a perfect indicator of stock value. The value of a stock clearly depends on future earnings and cash flows to the investor and not on past earnings. There is no way that a simple ratio of current earnings to current price can determine the value of a stock. But the P/E is used because current earnings provide the best available starting point in forecasting future earnings.

The use of current earnings in calculating a stocks value leads to two main pitfalls:

  1. The current earnings may not be representative. Current earnings may be affected by unusual gains and losses and by unusual economic conditions for the company. You must adjust the current year earnings and be certain that you use a representative starting point for earnings. This might include adjusting for unusual items or using an average of several year's earnings. Our research reports deal with this by providing you with up to five different P/E ratios. We calculate the P/E based on latest fiscal year current earnings, adjusted latest fiscal year earnings, previous fiscal year earnings, latest four quarters earnings and (where available) projected earnings.
  2. Key Learning - Never rely on a published P/E without checking if it has been affected by unusual earnings.

  3. A more difficult challenge lies in calculating a target P/E for a company. This depends partly on expected interest rates and inflation. This factor is not difficult as the yield on long term government bonds represents the market's best guess. The target P/E also depends on the company's specific projected growth in earnings per share and its specific risk factors. These two are very difficult to project. The best approach is probably to calculate past or forecast growth rates and then to calculate a target P/E at various potential levels of growth and risk. This may give quite a wide a wide range of target P/E ratios. Our research provides you with a calculation of past growth in earnings per share. A stock with an actual P/E trading near or below the targeted range of P/E would be a buy signal.

Another approach would be to try and judge the growth prospects and risk in comparison to very similar companies. Then, if the P/E seems low compared to this peer group after considering the differences in growth and risk then the P/E would indicate a buy signal. 

Key Learning: - You cannot make a logical judgment about a stock's P/E if you do not have some understanding of its earnings per share growth prospects and risk profile.

Shawn Allen, February 4, 2001

www.investorsfriend.com

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