All about the PE ratio

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 ------------------------------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

Estimated earnings are no longer in green and 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    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  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    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    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
 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

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

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

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.