What is the most widely used (abused?) stock valuation tool known to man? The price to earnings ratio (PE ratio) is a value metric that has as many fans but valuing stocks is not a popularity contest. You also know that reliance on just one method of stock valuation is short-sighted.
Now that I’ve gently attacked the PE ratio before giving it a chance, its only fair that I shed more light on how investors can use the PE ratio profitably to coincide with this weeks’ investing theme of the Shiller PE ratio over on Facebook.
How To Calculate The PE Ratio
Here’s the classic formula to calculate the PE ratio:
Share Price/Earnings Per Share
A Simple division really. Which is one of the reasons why it’s so popular and the main reason why I like it. If the share price of a stock you are interested in is £3.00 a share and it’s last reported earnings per share is £0.50 then it’s PE ratio would be 6:
3.00/ 0.50 = 6
Ben Graham insisted that large caps should have a PE ratio of no more than 20 in order to avoid growth stocks and no more than 9 for bargain stocks. Graham also insisted on additional valuation criteria.
Nice and simple.
Except that it’s not and here’s why: Earnings per share (EPS) can be derived from different sources depending on what data you are relying on.
What Numbers Do People Use To Calculate The PE Ratio?
The 3 most often used versions of EPS for the calculation of the PE ratio on financial websites are:
- The EPS reported from the accounts for the last 12 months – the PE ratio using these earnings is called the trailing PE ratio
- The EPS that a company should make in the future based on best guesses – this PE ratio is called either projected or forward PE and is based on broker’s forecasts.
- The EPS from the last two quarters and the best guesses of the next two quarters – a mixture of the two above that tries to minimise error by short-term forecasting. I’m unable to find a name for this PE ratio so can I call it the Pushmi Pullyu PE Ratio?
As you can see investors mainly have three choices by which they can value a stock based on its earnings.
My preference is for the trailing PE ratio (#1 above) because although a company may not produce the same rate of earnings in the future, I would rather know what they have produced in the long-term past to give me at least some idea of how they have performed. Besides, the future is unknown. But here’s the thing.
Benjamin Graham dedicated an entire chapter in The Intelligent Investor to earnings per share and gave two warnings to investors:
Don’t take a single year’s earnings seriously…If you do pay attention to short-term earnings, look out for booby traps in the per share figures. If our first warning were followed strictly, the second would be unnecessary. But it is too much to expect that most shareholders can relate all their common-stock decisions to the long-term record and the long-term prospects – pg 310, The Intelligent Investor
Evidently, Graham was exasperated at the attention investors gave to the PE ratio in the short-term. Accounting trickery, cyclical factors peculiar to an industry and general macro economic factors like recessions and downturns will all have an influence on earnings.
Can one year really be representative of a company’s ability to generate earnings?
How You Can Use The PE Ratio Profitably
Multi-year analysis of price to earnings as Graham suggested, is how I use the PE ratio and you can too: compare the current PE ratio to the 3 year, 5 year and 10 year averages to see if the current PE ratio is at or below these averages.
This type of multi-year analysis can iron-out swings in earnings, special charges, inflation and tax credits and debits that can influence EPS and should be included in EPS to get a complete picture of earnings.
This is one way in which the Shiller PE ratio is different: it strips out the influence of inflation to earnings over a period of 10 years to ‘normalise’ earnings.
I’m not comfortable with this type of data manipulation since earnings themselves are only accountants’ best guesses following a rigid set of rules applied to all company’s.
Trying to manipulate this data further only serves to muddy the waters which is why I’m more comfortable with raw data, even though it is based upon accountants’ best guesses. This is the most compelling reason why investors should not use the PE ratio in isolation to value a stock.
That is to say most value investors choose a crop of different ratios to get an overall picture when assessing a company for its potential undervaluation. If you enjoy valuing stocks, you may also like these posts:
- Value Investing; A Circle Of Competence
- Here’s A Watchlist Of US Stocks That Meet Value Investing Criteria
- How To Find Undervalued Stocks
- Now You Can Compare A Company Against It’s Peers In Less Than 5 Minutes
Image from: Stock Xchange