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
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
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
The use of current earnings in calculating a stocks value leads to two main
- 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.
Key Learning - Never rely on a published P/E without checking if it has
been affected by unusual earnings.
- 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
Shawn Allen, February 4, 2001