The P/E ratio is perhaps the most commonly used measure to express a stock’s relative value. It is also among the most misunderstood and misused variables.
Put simply, P/E, or price to earnings, is a valuation ratio of a company’s current share price compared to its per-share earnings. For example, Procter & Gamble earned $3.53 per share in fiscal 2010, so at a current price of approximately $64 per share, the stock’s P/E is 18.13 ($64 divided by $3.53). Perhaps a more accurate way to express the P/E is to use the estimated earnings number for the next full year, as the market is forward looking. This method provides us with the Forward P/E. For fiscal 2011, Procter & Gamble is projected to earn $3.95 per share by some estimates. At current prices, Procter & Gamble’s Forward P/E equals 16.20.
The first question that should be asked after seeing this analysis is “Is this a good P/E or a bad P/E?” The answer, in typical finance fashion, is “it depends.” Despite the relative simplicity in deriving a P/E, its application can be quite complicated. Several factors must be considered. Ideally, one would like to find a stock with a P/E ratio that is equal to, or below, the projected growth rate. Because Procter & Gamble’s projected compound growth rate, by some estimates, is 9.1%, a P/E of 18.13 might signal the stock is potentially overpriced. Likewise, if the growth rate were 25%, this would signal the stock is potentially under priced. Of course, more research would be warranted.
When you view a stock’s P/E in the context of its growth rate, you are only at a starting point. The P/E is a measure of relative value. The definitive answer to the question of whether a P/E ratio is good or bad is not a function of a stock’s growth rate, but also its relation to its sector. For example, stocks in the technology sector typically carry a much loftier P/E ratio, because the overall sector is rapidly growing relative to other sectors. Therefore, it is not uncommon to find P/E ratios of 50, 60 or even more, with growth rates of 25%-30%. A so-called “good” P/E in this context may be above the growth rate. Therefore, a thorough investor should compare the P/E ratio against the stock’s peers. On the other hand, lower P/Es are found in areas such as industrials, because of the volatility in earnings caused by unstable commodity prices. Therefore, you should not compare the P/E of Procter & Gamble to Apple, Inc., and cite that one stock is necessarily cheaper than the other. Rather, you should look at & Gamble against other similar personal products companies. Apple, Inc. should be looked at in the context of other computer/software companies.
There are many ways to approach valuing a stock. As complicated or convoluted as a P/E analysis can get, it really only scratches the surface in the comprehensive process the Henssler Research staff undertakes in pinning a price on a stock. Even though the P/E is not a great stand-alone measure of value, the P/E ratio is indeed a useful measure to get a quick idea of a company’s relative valuation. A P/E ratio can also tell you what the market thinks of a stock. For example, if a company has a really high P/E, the market is typically telling you it believes the company offers high growth potential compared to peers and market leadership. Some examples of companies with high P/E ratios as of December 15, 2010, are C.H. Robinson, Inc. (CHRW); Panera Bread (PNRA); Netflix (NFLX), and Amazon (AMZN). The same analysis of the P/E ratio also applies to other relative value measures, including Price/Book, Price/Sales, and Price/Cash Flow, to name a few.
The last point to keep in mind is to always double check the data you are using. Many people are taking advantage of the abundance of free information on stocks available on the Internet. The problem with this is that not all data providers are alike. Some compute the P/E ratio using last year’s earnings, while others use projected earnings or the sum of the most recent four quarters. In addition, projections for growth may be stale or erroneous. Therefore, when you do your research, you can either compute these measures yourself, or be sure to reference several sources and look for consistency in the data to ensure your data provider is accurate. If you find one source to be fairly accurate, be sure to use that source exclusively to avoid using someone else’s potentially bad data. Other things to pay attention to include consistency of earnings growth (have earnings always increased, or are they inconsistent); the rate of change in the growth rate (is it accelerating or decelerating), and the longevity of the growth rate (will growth be strong only this year and then taper off, or will it continue to remain at its noted level). These tips should help make your analysis more useful, and potentially, more rewarding. For more information regarding this topic, please contact Henssler Financial at 770-429-9166, or [email protected].