Thursday, June 19

All about P/E Ratio

P/E Ratio
The P/E ratio (price-to-earnings ratio) of a stock (also called its "earnings multiple", or simply "multiple", "P/E", or "PE") is a measure of the price paid for a share relative to the income or profit earned by the firm per share. A higher P/E ratio means that investors are paying more for each unit of income. It is a valuation ratio included in other financial ratios. The reciprocal of the P/E ratio is known as the earnings yield.

P/E Ratio = Price per Share / Earnings per Share

The price per share (numerator) is the market price of a single share of the stock. The earnings per share (denominator) is the net income of the company for the most recent 12 month period, divided by number of shares outstanding. The earnings per share (EPS) used can also be the "diluted EPS" or the "comprehensive EPS".
For example, if stock A is trading at $24 and the earnings per share for the most recent 12 month period is $3, then stock A has a P/E ratio of 24/3 or 8. Put another way, the purchaser of stock A is paying $8 for every dollar of earnings. Companies with losses (negative earnings) or no profit have an undefined P/E ratio (usually shown as Not applicable or "N/A"); sometimes, however, a negative P/E ratio may be shown.
By relating price and earnings per share for a company, one can analyze the market's stock valuation of a company and its shares relative to the income the company is actually generating. Investors can use the P/E ratio to compare the value of stocks: if one stock has a P/E twice that of another stock, all things being equal, it is a less attractive investment. Companies are rarely equal, however, and comparisons between industries, countries, and time periods may be misleading.
Determining share prices
Share prices in a publicly traded company are determined by market supply and demand, and thus depend upon the expectations of buyers and sellers. Among these are:
· The company's future and recent performance, including potential growth;
· Perceived risk, including risk due to high leverage;
· Prospects for companies of this type, the "market sector".
By dividing the price of one share in a company by the profits earned by the company per share, you arrive at the P/E ratio. If earnings move up in line with share prices (or vice versa) the ratio stays the same. But if stock prices gain in value and earnings remain the same or go down, the P/E rises.
The price used to calculate a P/E ratio is usually the most recent price. The earnings figure used is the most recently available, although this figure may be out of date and may not necessarily reflect the current position of the company. This is often referred to as a trailing P/E, because it involves taking earnings from the last four quarters; the 'forward P/E' (or current price compared to estimated earnings going forward twelve months) is also used.

Interpretation
The average U.S. equity P/E ratio from 1900 to 2005 is 14 (or 16, depending on whether the geometric mean or the arithmetic mean is used to average), meaning it takes about 14 years for a company you purchase to earn back your full purchase price for you.
Normally, stocks with high earning growth are traded at higher P/E values. For example, stock A may be expected to earn $6 per share the next year. Then the forward P/E ratio is $24/6 = 4. So, you are paying $4 for every one dollar of earnings, which makes the stock more attractive than it was the previous year.
The P/E ratio implicitly incorporates the perceived riskiness of a given company's future earnings. For a stock purchaser, this risk includes the possibility of bankruptcy. For companies with high leverage (that is, high levels of debt), the risk of bankruptcy will be higher than for other companies. Assuming the effect of leverage is positive, the earnings for a highly-leveraged company will also be higher. In principle, the P/E ratio incorporates this information, and different P/E ratios may reflect the structure of the balance sheet.
Variations on the standard trailing and forward P/E ratios are common. Generally, alternative P/E measures substitute different measures of earnings, such as rolling averages over longer periods of time (to "smooth" volatile earnings, for example), or "corrected" earnings figures that exclude certain extraordinary events or one-off gains or losses. The definitions may not be standardized.
Various interpretations of a particular P/E ratio are possible, and the historical table below is just indicative and cannot be a guide, as current P/E ratios should be compared to current real interest rates:

N/A

A company with no earnings has an undefined P/E ratio. By convention, companies with losses (negative earnings) are usually treated as having an undefined P/E ratio, although a negative P/E ratio can be mathematically determined.

0-10

Either the stock is undervalued or the company's earnings are thought to be in decline. Alternatively, current earnings may be substantially above historic trends.

10-17

For many companies a P/E ratio in this range may be considered fair value.

17-25

Either the stock is overvalued or the company's earnings have increased since the last earnings figure was published. The stock may also be a growth stock with earnings expected to increase substantially in future.

25+

A company whose shares have a very high P/E may have high expected future growth in earnings or the stock may be the subject of a speculative bubble.

It is usually not enough to look at the P/E ratio of one company and determine its status. Usually, an analyst will look at a company's P/E ratio compared to the industry the company is in, the sector the company is in, as well as the overall market (usually the S&P 500). Sites such as Reuters offer these comparisons in one table. Example of RHAT Often, comparisons will also be made between quarterly and annual data. Only after a comparison with the industry, sector, and market can an analyst determine whether a P/E ratio is high or low with the above mentioned distinctions (i.e., undervaluation, over valuation, fair valuation, etc).

The Market P/E

To calculate the P/E ratio of a market index such as the S&P 500, it is not accurate to take the "simple average" of the P/Es of all stock constituents. The preferred and accurate method is to calculate the weighted average. In this case, each stock's underlying market cap (price multiplied by number of shares in issue) is summed to give the total value in terms of market capitalization for the whole market index. The same method is computed for each stock's underlying net earnings (earnings per share multiplied by number of shares in issue). In this case, the total of all net earnings is computed and this gives the total earnings for the whole market index. The final stage is to divide the total market capitalization by the total earnings to give the market P/E ratio. The reason for using the weighted average method rather than 'simple' average can best be described by the fact that the smaller constituents have less of an impact on the overall market index. For example, if a market index is composed of companies X and Y, both of which have the same P/E ratio (which causes the market index to have the same ratio as well) but X has a 9 times greater market cap than Y, then a percentage drop in earnings per share in Y should yield a much smaller affect in the market index than the same percentage drop in earnings per share in X.

An example
An easy and perhaps intuitive way to understand the concept is with an analogy:
Let's say, I offer you a privilege to collect a dollar every year from me forever. How much are you willing to pay for that privilege now? Let's say, you are only willing to pay me 50 cents, because you may think that paying for that privilege coming from me could be risky. On the other hand, suppose that the offer came from Bill Gates, how much would you be willing to pay him? Perhaps, your answer would be at least more than 50 cents, let's say, $20. Well, the price earnings ratio or sometimes known as earnings multiple is nothing more than the number of dollars the market is willing to pay for a privilege to be able to earn a dollar forever in perpetuity. Bill Gates's P/E ratio is 20 and my P/E ratio is 0.5.
Now view it this way: The P/E ratio also tells you how long it will take before you can recover your investment (ignoring of course the time value of money). Had you invested in Bill Gates, it would have taken you at least 20 years, while investing in me could have taken you less than a year, that is, only 6 months.
If a stock has a relatively high P/E ratio, let's say, 100 (which Google exceeded during the summer of 2005), what does this tell you? The answer is that it depends. A few reasons a stock might have a high P/E ratio are:
· The market expects the earnings to rise rapidly in the future. For example a gold mining company which has just begun to mine may not have made any money yet but next quarter it will most likely find the gold and make a lot of money. The same applies to pharmaceutical companies — often a large amount of their revenue comes from their best few patented products, so when a promising new product is approved, investors may buy up the stock.
· The company was previously making a lot of money, but in the last year or quarter it had a special one time expense (called a "charge"), which lowered the earnings significantly. Stockholders, understanding (possibly incorrectly) that this was a one time issue, will still buy stock at the same price as before, and only sell it at least at that same price.
· Hype for the stock has caused people to buy the stock for a higher price than they normally would. This is called a bubble. One of the most important uses for the P/E metric is to decide whether a stock is undergoing a bubble or an anti-bubble by comparing its P/E to other similar companies. Historically, bubbles have been followed by crashes. As such, prudent investors try to stay out of them.
· The company has some sort of business advantage which seems to ensure that it will continue making money for a long time with very little risk. Thus investors are willing to buy the stock even at a high price for the peace of mind that they will not lose their money.
· A large amount of money has been inserted into the stock market, out of proportion with the growth of companies across the same time period. Since there are only a limited amount of stocks to buy, supply and demand dictate that the prices of stocks must go up. This factor can make comparing P/E ratios over time difficult.
· Likewise, a specific stock may have a temporarily high price when, for whatever reason, there has been high demand for it. This demand may have nothing to do with the company itself, but may rather relate to, for example, an institutional investor trying to diversify out risk.

Inputs
Accuracy and context
In practice, decisions must be made as how to exactly specify the inputs used in the calculations.
· Does the current market price accurately value the organization?
· How is income to be calculated and for what periods? How do we calculate total capitalization?
· Can these values be trusted?
· What are the revenue and earnings growth prospects over the time frame one is investing in?
· Was there special one time charges which artificially lowered (or artificially raised) the earnings used in the calculation, and did those charges cause a drop in stock price or were they ignored?
· Were these charges truly one-time, or is the company trying to manipulate us into thinking so?
· What kind of P/E ratios is the market giving to similar companies, and also the P/E ratio of the entire market?

Historical vs. Projected Earnings
A distinction has to be made between the fundamental (or intrinsic) P/E and the way we actually compute P/Es. The fundamental or intrinsic P/E examines earnings forecasts. That is what was done in the analogy above. In reality, we actually compute P/Es using the latest 12 month corporate earnings. Using past earnings introduces a temporal mismatch, but it is felt that having this mismatch is better than using future earnings, since future earnings estimates are notoriously inaccurate and susceptible to deliberate manipulation.
On the other hand, just because a stock is trading at a low fundamental P/E is not an indicator that the stock is undervalued. A stock may be trading at a low P/E because the investors are less optimistic about the future earnings from the stock. Thus, one way to get a fair comparison between stocks is to use their primary P/E. This primary P/E is based on the earnings projections made for the next years to which a discount calculation is applied.

A Forward PE Ratio refers to PE Ratio using earnings estimates for the next four quarters while a Trailing PE Ratio refers to the PE Ratio using EPS of the last four quarters

Trailing PE Ratio = Current Market Price per share / EPS of the last four quarters.

Leading PE Ratio = Current Market Price per share / (EPS of the last four quarters x (1+Growth rate))


The P/E Concept in Business Culture
The P/E ratio of a company is a significant focus for management in many companies and industries. This is because management is primarily paid with their company's stock (a form of payment that is supposed to align the interests of management with the interests of other stock holders), in order to increase the stock price. The stock price can increase in one of two ways: either through improved earnings or through an improved multiple that the market assigns to those earnings. As mentioned earlier, a higher P/E ratio is the result of a sustainable advantage that allows a company to grow earnings over time (i.e., investors are paying for their peace of mind). Efforts by management to convince investors that their companies do have a sustainable advantage have had profound effects on business:
· The primary motivation for building conglomerates is to diversify earnings so that they go up steadily over time.
· The choice of businesses which are enhanced or closed down or sold within these conglomerates is often made based on their perceived volatility, regardless of the absolute level of profits or profit margins.
· One of the main genres of financial fraud, "slush fund accounting" (hiding excess earnings in good years to cover for losses in lean years), is designed to create the image that the company always slowly but steadily increases profits, with the goal to increase the P/E ratio.
These and many other actions used by companies to structure themselves to be perceived as commanding a higher P/E ratio can seem counterintuitive to some, because while they may decrease the absolute level of profits they are designed to increase the stock price. Thus, in this situation, maximizing the stock price acts as a perverse incentive.

Dividend Yield
Publicly traded companies often make periodic quarterly or yearly cash payments to their owners, the shareholders, in direct proportion to the number of shares held. According to US law, such payments can only be made out of current earnings or out of reserves (earnings retained from previous years). The company decides on the total payment and this is divided by the number of shares. The resulting dividend is an amount of cash per share. The dividend yield is the dividend paid in the last accounting year divided by the current share price.
If a stock paid out $5 per share in cash dividends to its shareholders last year, and its price is currently $50, then it has a dividend yield of 10%.
Historically, at severely high P/E ratios (such as over 100x), a stock has NO (0.0%) or negligible dividend yield. With a P/E ratio over 100x, and supposing a portion of earnings is paid as dividend, it would take over a century to earn back the purchase price. Such stocks are extremely overvalued, unless a huge growth of earnings in the next years is expected.

Earnings yield
The reverse (or reciprocal) of the P/E is the E/P, also known as the earnings yield. The earnings yield is quoted as a percentage, and is useful in comparing a stock, sector, or the market's valuation relative to bonds.
The earnings yield is also the cost to a publicly traded company of raising expansion capital through the issuance of stock.

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