The PE ratio is one of the more commonly
available pieces of information about a publicly traded company. The
calculation is simple: it's the share price divided by the annual earnings per
share. In a sense, the PE ratio is a way to normalize the price of a company to
its earnings and allows a person to compare one company with another. For
example, if company ABC is trading at $50 a share and generates $5 in earnings
in a 12-month period, it has a PE ratio of 10 (50 ÷ 5 = 10), while company XYZ
is trading at $18 a share, but produces only $1 a share in earnings, it has a
PE ratio of 18 (18 ÷ 1 = 18), if the companies are very similar, at first blush
you might say that ABC is trading at a better value than is XYZ−of course more
analysis is needed, but this result alone should convince a person to
investigate further to see if this difference is warranted. This issue will be
touched on later and discussed in more detail in another blog.

**The stock price**

It doesn't matter which stock price you use as long as the price
used corresponds to a period in time when the earnings were generated. If the
company has a calendar fiscal year and you are looking at the PE on November
15, you might use the last four quarters of reported earnings per share. That
is, you'd use the most recent four quarters of information that is available to
you. The issue of earnings will be discussed next. Suffice it to say, a price
from 2011 and earnings from 1948 don't yield meaningful information when
combined!

**Fiscal Year and Calendar Year**

Everyone is already familiar with the term "calendar
year": a calendar year stretches from January 1 until December 31.
Companies report results periodically, every three months; these results are called
quarterly reports. Once a year, the company issues a more detailed, annual
report. All companies have a fiscal year for accounting purposes: twelve months
in which four quarterly reports are published. For most companies this fiscal
year is identical to the calendar year: it starts on January 1 and ends on
December 31. However, you will find quite a few companies that have fiscal
years which don't match the calendar year. If they work with the government,
their fiscal year might start on October 1 and end the following September 30.
Some retailers avoid closing out the fiscal year around the Christmas holidays,
since they're busy doing other things then. So, when I use the term fiscal
year, I am just referring to an accounting period of twelve months which
usually, but not always, overlaps with the regular calendar year.

**Figuring out the Earnings per share**

Determining the earnings per share or EPS is a little trickier.
There are really three different ways, maybe four, that people use to determine
earnings. In this section, I will use McDonald's
Corporation[NYSE:MCD] as an example. It turns out that McDonald's
has a fiscal year that matches the calendar year, so, when I talk about the
third quarter, for example, I'm talking about July through September. On
January 4, 2011, McDonald's closed at a price of $74.31 during regular trading
hours. It last reported earnings for the quarter ending September 2010, when it
earned $1.29 a share. For the last four quarters, the company had earnings of

2009 2010 2010 2010

Q4 Q1 Q2 Q3

$1.03 $1.03 $1.13 $1.29

There are many sources for this information; I took the data fromDailyFinance. Since we'll need more information in the next few subsections, the next table provides earnings for the full 2009 calendar year together with projected earnings for the next four quarters.

2009 2010 2010 2010

Q4 Q1 Q2 Q3

$1.03 $1.03 $1.13 $1.29

There are many sources for this information; I took the data fromDailyFinance. Since we'll need more information in the next few subsections, the next table provides earnings for the full 2009 calendar year together with projected earnings for the next four quarters.

---------------- 2009 ---------------------------- 2010
------------------------------2011

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3

0.83 0.97 1.15 1.03 1.03 1.13 1.29

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3

0.83 0.97 1.15 1.03 1.03 1.13 1.29

*1.16 1.10 1.23 1.41*
Estimated earnings are no longer in green and

Estimated earnings will be in green when Zecco learns how to implement HTML correctly in their blogs!

*italicized*; they're the earnings for the fourth quarter of 2010 and the first three quarters of 2011. As of January 4, 2011, these numbers had not yet been reported. To determine any rolling four quarter earnings figure, just add together four consecutive numbers.Estimated earnings will be in green when Zecco learns how to implement HTML correctly in their blogs!

**Historical Earnings**

Some people use what's called "historical earnings," which are the last four quarters of reported data. You'll often see those earnings described as "trailing twelve month," abbreviated as "ttm." Check out the quote for McDonald's on Yahoo! As discussed above, we're going to calculate the PE ratio based on the closing price for McDonald's of $74.31 on January 4, 2011. To calculate a trailing twelve month or historical PE ratio, we use the last four reported numbers, which are the first, second and third quarters for 2010 and the fourth quarter from 2009.

----------------
2009 ---------------------------- 2010 ------------------------------2011

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3

0.83 0.97 1.15

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3

0.83 0.97 1.15

**1.03 1.03 1.13 1.29***1.16 1.10 1.23 1.41***$4.48**
So, for the past four quarters the company earned $4.63 a share
($1.03 + $1.03 + $1.13 + $1.29 = $4.48). Dividing $4.48 into the stock price of
$74.31 gives a PE ratio of 16.6. ($74.31 ÷ $4.48 = 16.6)

**Future or Forward Looking Earnings**

Some people use "forward looking" or "projected" earnings to calculate a PE ratio: they take the next four quarters of earnings as estimated by analysts knowledgeable about a given company. These four quarters of projected earnings are then summed together and used as the denominator in calculating a PE ratio. Since the earnings are "forward looking," this type of PE ratio is often called a projected or forward looking PE ratio. Let's look at the example of McDonald's.

----------------
2009 ---------------------------- 2010 ------------------------------2011

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3

0.83 0.97 1.15 1.03 1.03 1.13 1.29

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3

0.83 0.97 1.15 1.03 1.03 1.13 1.29

*1.16 1.10 1.23 1.41*

*$4.90*
On January 4, 2011, the last reported quarter for McDonald's,
which was the third quarter for fiscal year 2010, was $1.29. The projected
earnings for the next four quarters follow. They add up to $4.90. So the PE
ratio based on the closing price on January 4, 2011 is 15.2 ($74.31 ÷ $4.90 =
15.2). As long as the earnings are growing, the projected PE ratio for a
company is always higher than the one based on the trailing four quarters EPS
figures.

So is this number out of whack? Let's see. Let's calculate the PE
ratio for January 4, 2010−exactly one year ago−using actual earnings reported
by McDonalds.

---------------- 2009 ---------------------------- 2010 ------------------------------2011

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3

0.83 0.97 1.15

---------------- 2009 ---------------------------- 2010 ------------------------------2011

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3

0.83 0.97 1.15

**1.03 1.03 1.13 1.29***1.16 1.10 1.23 1.41*

**$4.48**
I really should go back to the website I discussed earlier and use
the forecasted figures that analysts devised a year ago, but for the purposes
of illustrating the process, I will assume that some genius analyst projected
the four quarters of earnings exactly to the penny! Not surprisingly what would
have been forecasted earnings in January 2010 come out to be $4.48. On January
4, 2010, MCD closed at a price of $62.78, so the forward looking PE ratio on
that date would have been 14.0 ($62.78 ÷ $4.48 = 14.0). It's in the ballpark.

**Mixed Earnings**

Finally Value Line, the famous and widely followed investment survey, uses the two most recently published quarters of data together with the next two estimated quarters of earnings: four quarters gives a year of data. The estimates are determined by analysts that work at Value Line.

----------------
2009 ---------------------------- 2010 ------------------------------2011

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3

0.83 0.97 1.15 1.03 1.03

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3

0.83 0.97 1.15 1.03 1.03

**1.13 1.29***1.16 1.10**1.23 1.41***$4.68**

If we follow approach adopted by Value Line, we'd use the earnings reported in Q2 and Q3 of 2010 together with the forecasted figures for Q4-2010 and Q1-2011. Those four numbers added together give $4.68. Once again, using the closing price on January 4, 2011 of $74.31 gives a PE ratio of 15.9 ($74.31 ÷ $4.68 = 15.9). By the way, since McDonald's is a component of the Dow Jones Industrial Average, you can download a Value Line report for any member of the Dow, including McDonald's, for free.
Note, I made estimates for the projected earnings for MCD which
differ a little from those estimated by Value Line. There are a number of
reasons for the difference including how Value Line elects to treat components
of earnings that it considers non-recurring. These difference don't impact how
the PE ratio is calculated. Sources of earnings and things that can impact the
EPS will be the focus of another blog.

**Last Fiscal Year Earnings**

I mentioned that there might be a fourth way. Some people use the last report fiscal year earnings and divide it into the share price. It gives a PE ratio, but the greater the "distance" between the Price and the Earnings, the less meaningful does the ratio become. For example, if you're analyzing a company where the earnings are growing at a rate of, say, 15% annual, then if you're calculating a PE ratio in December of 2010 using fiscal year earnings reported for the end of calendar year 2009, the EPS is lower than the actual figure about to be reported and, as a result, you might end up with a PE ratio that's higher than it should be.

----------------
2009 ---------------------------- 2010 ------------------------------2011

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3

**0.83 0.97 1.15 1.03**1.03 1.13 1.29*1.16 1.10 1.23 1.41***$3.98**
Since McDonald's is a growing company with earnings increasing
year over year, the PE ratio calculated on the last full fiscal year should
yield the

*highest*figure. Once again, using the closing price on January 4, 2011 of $74.31 together with the fiscal year 2009 earnings of $3.98 gives a PE ratio of 18.7.
For the most part, when people use the last full fiscal year to
calculate a PE ratio, they rarely use the current price in the determination.
The most common price to use is an

*average*price for that fiscal year. For MCD the average price in 2009 was somewhere around $57.6. So, using the earnings figure of $3.98, the PE ratio becomes 14.5 ($57.6 ÷ $3.98 = 14.5). How the average price for a past year is determined is a topic for another blog!**Which type of PE ratio should I use?**

If you're using the PE ratio as a criterion
in a purchase decision, it's important to use as current as information as is
possible. So using the most recent four quarters is preferable. There's a very
good argument to be made that using four quarters of projected earnings makes
even more sense, since you're buying a company for what it will do not what it
has done.

When looking at a PE ratio, it's important to
know from where those earnings come. Some sources use forecasted earnings,
others use historical information. As a result a published PE on a given
company for a given price can be different.

Finally, whatever PE ratio you use (projected
earnings, trailing twelve months, etc.) when comparing PE ratios, make sure you
use ratios that are calculated using similar earnings (historical versus
projected).

**Ways to think about the PE ratio**

I focus on earnings as among the most important
things that a company delivers. In fact, when analyzing companies, I use
earnings as the key driver of each step in the process. Many use cash
flow--either operation or free cash flow; however, I have found that earnings
can tell a better story: more correctly, earnings are more widely available in
some shape or form, so I start with earnings first.

Earnings, net income, is what's left over after all expenses have
been paid; some use the term profit as a synonym for earnings. Earnings are
either retained or paid to shareholders as a dividend. In fact, most companies
(except for REITs) that have dividends, pay a portion to shareholders and keep
most of the earnings to fuel future growth. These retained earnings, the
portion not paid as a dividend, end up in the shareholders equity portion of
the balance sheet. If the board of directors of a company wanted to, it could
pay out all the earnings as dividends; however, that decision doesn't happen in
reality.

Knowing that earnings could be paid out to a shareholder, gives
you a way to look at the EPS: in a sense, the earnings per share is your money.
The board of directors has elected to retain it to help grow the company
future, but they're your funds and the PE ratio is simply a way of say how much
an investor is will to pay to "own" those earnings.

For example, if the PE ratio is 15, then a knowledgeable investor
is willing to pay $15 for every $1 in earnings.

Another way to think about PE is as a time to pay back an
investment. A PE ratio of 15 is telling you that if the company continues to
generate the same earnings year after year, it would take 15 years to
accumulate enough earnings to reach the current price of the stock.

Of course, companies don't pay out 100% of earnings to
shareholders; in growing companies, earnings increase in each successive year,
so this hypothetical payback period is actually shorter. These two ideas are
just ways to look at the PE ratio.

Some people like to turn the PE ratio upside down and think of it
as a percentage. So, inverting a PE of 15 gives (1 divided by 15) or 0.0667.
Expressed as a percentage, you get 6.67%. It's essentially, viewed as a return.

**The PE Ratio Changes over Time**

Earnings are issued once per quarter, but the stock is traded
every day the market is open. The millions of participants in the market have
different opinions about the value of the company, so, depending on who's
buying or selling, the share price can move up or down. The earnings stay the
same for three months, but the price moves. Since the PE ratio is the price
divided by earnings, the PE ratio moves with the price. The average stock on
the New York Stock Exchange has a price difference of almost 50% between its
high and low for the year: that's a large difference. In a later post, I will
discuss how some investors benefit from this difference to try and buy
companies when they're undervalued. Suffice it to say that the PE ratio changes
over time--it moves in a band from low to high.

**The PE Ratio and the Implied Rate of Growth of a Company**

As you may have started to wonder from the previous discussion,
the PE ratio signals something about the growth prospects for a company.Peter Lynch,
who was the legendary manager of the Fidelity Magellan Fund, spoke about the PE ratio
and growth in his book One Up on Wall Street. Fast growing companies
tend to have a higher PE ratio than do slow growers. Peter Lynch observed a
correlation between PE ratio and earnings growth and, in his 1989 classic book,
made the famous utterance "the PE ratio of any company that's fairly
priced will equal its growth rate."

In fact, you can look on websites such as Yahoo! or MoneyCentral
yourself. Banks tend to have slow revenue growth over time; they also trade at
low PE ratios. Companies in slower growing industries tend to have lower
average PE ratios than companies in fast growing industries. In the 1990s,
companies such as AOL grew quickly and earned high PE ratios. Many analysts use
forward or estimated earnings for PE ratios; using forward looking earnings
inevitably pushes up the PE ratio on today's stock prices for fast growth
companies. When comparing PE ratios from one company to the next, it makes more
sense to make comparisons between or among companies within the

*same*industry or sector. Comparing PE ratios across industries can sometimes lead to spurious conclusions.
This correlation between the PE growth rate and the earnings per
share growth rate is often itself express as a ratio called the "PEG
ratio" or PE to Growth ratio. This concept will be discussed a little more
in a later blog.

**How the PE Ratio could be used to project the stock price**

This section will show how you can use a PE ratio to come up with
a possible future stock price. The PE ratio is only one of the things you would
use, but the application is simple. The results don't tell you what you should
do; they simply provide you with one more datum point in your decision making
process. Did you like the way I got datum in there? Let's say that today a
company earns $1 per share. If analysts claim--and history supports--a growth
rate of 20% annually, to figure out earnings in five years, just calculate what
$1 will become if it grows at 20% annually. For those of you who are
math-challenged, here's that calculation. Let's say it's 2010 and the company
reports $1 per share for 2010 early in 2011. What would the earnings be at the
end of 2011? You're going to multiply $1 by 1.20; that is, increase $1 by 20%;
repeat that step five times and you have the earnings in five years.

2010: $1.00 x 1.20 = $1.20

2011: $1.20 x 1.20 = $1.44

2012: $1.44 x 1.20 = $1.73

2013: $1.73 x 1.20 = $2.07

2014: $2.07 x 1.20 = $2.49

2015: $2.49

2011: $1.20 x 1.20 = $1.44

2012: $1.44 x 1.20 = $1.73

2013: $1.73 x 1.20 = $2.07

2014: $2.07 x 1.20 = $2.49

2015: $2.49

If the earnings grow steadily at 20% a year, then by 2015 (five
years from now), the company should be earning $2.49.

You can convert these earnings into a stock price. Remember, the
PE ratio is simply a stock price divided by earnings. So if you have the
earnings and you think you know what the PE ratio will be, then the price is
simply the PE ratio times those earnings.

I mentioned earlier that earnings change once per quarter, but
prices change all the time, so the PE ratio is constantly on the move too.
Let's say that historically, the PE ratio of the company moves between a low of
15 and a high of 25 in a given year. Using this information, the stock price
would probably move between $15 and $25--somewhere in that range. (Remember
price = PE ratio x earnings per share)

**Results in 2011**

Low end: $1.00 x 15 = $15.0

High end: $1.00 x 25 = $25.0

High end: $1.00 x 25 = $25.0

You've projected the 2015 earnings for the company based on the
EPS value, so the price range--using historical PE ratios--is

**Results in 2015**

Low end: $2.49 x 15 = $37.3

High end: $2.49 x 25 = $62.2

High end: $2.49 x 25 = $62.2

This analysis suggests that there's a good chance that if you can
buy the stock at a price today where it's likely to double in five years. In
fact, if the company is trading at $20 today, there's a good chance it will
over $40 a share by 2015.

Keep in mind, in this analysis, I used historical information
about the PE ratio and projected earnings per share values based on analysts'
estimates to come up with a future possible stock price. I'll use this
technique in a future blog, when I discuss a tool called the Stock Selection
Guide.

**PE Ratios Expand and Contract with Time**

Aside from the correlation between the PE ratio and the
anticipated growth of earnings for a company, PE ratios for all companies tend
to expand and contract over time. Low interest rates have traditionally cause
"PE ratio expansion"; that is, the average PE ratio of all companies
(which impacts the PE ratio of indices such as the S&P 500) tends to increase.
High interest rates tend to put a damper on PE ratios. The reason is pretty
simple. When interest rates are low and satisfactory returns cannot be achieved
in savings accounts or low risk bonds, some investors put more of their assets
into higher risk investments such as stocks. With more people chasing a fixed
supply of equities, prices are driven up, which drives the PE ratio up too.
When interest rates are high, as they were in the early 1980s, investors can
realize high returns in investments with less risk than stocks, so prices are
often bid down (fewer people interested in purchasing), so the average PE ratio
falls too.

The take home lesson is that PE ratios are influenced by
prevailing interest rates, with a low interest rate environment causing PE
ratios to expand and higher interest rates causing them to contract. Other
things drive prices, not just interest rates, but PE ratios tend, on average,
to respond to interest rates.

**PE Ratios for Cyclical Companies**

The overall economy, often measured by the GDP for a country or
region, expands and contracts over time. This expansion and contraction is
referred to as the business cycle. Companies with revenues that follow the
business cycle are usually called cyclical companies. Growth company revenues
are only very slightly affected by the business cycle.

The PE ratio for cyclical companies tends to behave in a
counterintuitive manner. A high PE is, perversely, usually a good sign; a low
PE is a warning. The reason is that as a cyclical company, which often has high
fixed costs, starts to recover from a recession, earnings turn positive. Right
at the point of recovery, the trailing twelve month earnings often consisits of
three quarters of loss and one quarter with a small profit; the sum of these
four numbers is still negative, but the company is recovering. When the
earnings eventually become positive, they're often a small number. If the
company pays a dividend, there's usually price below which the shares don't
drop. So you end up with small but growing earnings divided into a reasonably
stable share price: you get a high number for the PE ratio. Conversely, when
the company is on top of its game, with high, positive earnings, the PE can
look low. It's important to know if the company you're looking at has cyclical
earnings

*before*you try to interpret the PE ratio.**So How Should the PE Ratio be Used?**

The PE ratio is just one
statistic that should be examined when determining if it's the right time to
buy the company. I believe that the best way to use the PE ratio is to compare
it to the average PE ratio for that company. The current PE ratio divided by
the historical average PE ratio is often referred to as the relative value or
RV. So all else being equal, if the RV is 1.0 or thereabouts, the company is
fairly valued; if it is less than 1.0, the company

*might*be a buy; greater than 1.0, the company might be fully or over valued.
The first thing to determine is if anything fundamental has
changed.

·
Has the earnings outlook
for the company changed?

·
Are there new
competitors in the market place?

·
Did the company lose key
employees? Has there been a change in management?

·
Have the revenues for
the company slowed down?

·
Has some regulatory
change impacted the entire industry?

If the external environment remains the same, all else being
equal, a low PE is a factor in the buy decision. If the company is trading at
or near its 52-week low, that's yet another good sign. Finally, if the PE ratio
has a value that is lower than the average PE ratio

*for that company*for the past few years, it's another sign you might be looking at a good price.
In a later blog, I will other factors in the buying decision for
buy-and-hold, long-term investors. The PE ratio will feature there too.

**Summary**

The PE ratio is simply the price of the stock divided by the
earnings per share.

· The earnings can be
calulated in different ways and its important when comparing the PE ratio to
(i) know how it's calculated and (ii) to use the same methodology when comparing
one PE ratio with another.

·
The PE ratio tells you
something about the anticipated growth in earnings of a company: companies with
above average growth rates tend to have above average PE ratios.

·
PE ratios tend to be
industry specific, so when making comparisions between or among companies, it's
important that they be in the same industry or sector.

·
All else being equal, PE
ratios tend to expand when interest rates are low and contract when they are
high.

·
PE ratios for cyclical
companies behave counterintuitively: a high PE ratio can be a good sign; a low
PE ratio can be a bad sign.

·
The current PE ratio for
a company divided by its historical average PE ratio gives the relative value.
A value less than 1.00 can mean that a company is competitively priced.

·
All else being equal,
companies should be purchased when the PE ratio is lower than it normally has
been in the past.

·
The leading company in
an industry usually trades at a higher average PE ratio than its peers. It
often has the best profit margin and earnings growth rate.

The PE ratio will be revisited in later blogs and discussed in the
context of other metrics needed to make an informed buy decision.