Fundamental Investment 101 – Price/Earnings
This is part of a series of very basic fundamental investment principles. I will try to explain in no-nonsense terms the simplest concepts of fundamental investing and how to apply them when researching stocks.
This series includes the most necessary information for comparative valuation – it is not a financial analysis guide and will try to keep things as simple as possible.
What is the Price / Earnings Ratio?
Price/Earnings or P/E is the most widely used valuation metric for stocks (equities). The ratio expresses a company’s share price divided by the earnings per share (EPS).
Earnings per share (EPS) is calculated by dividing the net profit of a company by the number of outstanding shares.
If ACME Corp. generated a net profit of $1.5bn last year and they have 200mn shares outstanding, the earnings per share is 1,500,000,000 / 200,000,000 = $7.5 EPS
If one share of ACME Corp is trading at $75 the P/E of ACME Corp. is $ 75 / $7.5 = 10 (or 10-times or 10x)
Image Credit: Markus Winkler
The ratio is thus a multiple of the earnings attributable to each shareholder (or individual share to be precise).
It also means that if ACME Corp is going to generate the same profit for the next consecutive 10 years, the company’s earnings per share will have surpassed the purchase price of a single share.
Why is the P/E ratio important?
One can say a low P/E is an indication of a cheap (or attractive) company and a high P/E is an indication of an expensive (or unattractive) company.
However, this is not necessarily true in every case. Companies that are growing rapidly are valued at a higher price-to-earnings ratio because they are going to generate more profits in the future years than today.
On the reverse, companies in decline often appear cheap on a price to price/earnings basis but they are expected to have shrinking profits in the future and might turn into loss-making companies.
Such companies are sometimes called value-traps.
Examples are Blackberry (BB) who have traded cheap on a P/E basis throughout the noughties but their share price continued to decline, for known reasons.
Another anecdotal example of a value-trap of the noughties is Pitney Bowes (PBI), a producer of postage meter machines, which had declining sales due to the rise of the internet.
It is important not to look at the price-earnings ratio in an isolated manner, but also consider industry, peer-group and expected growth rate and to look at a company in a relative-value manner.
Historic Price/Earnings (PE) or Trailing P/E ratio
The price-earnings ratio based on the previous financial year’s net profit and current share price.
Forward Price/Earnings (PEe) or expected Price/Earnings
The price-earnings ratio is based on the ongoing financial year’s expected net profit (usually based on the median estimate by wall-street analysts) and the current share price.
The forward price/earnings ratio includes the expected earnings growth for the current financial year and is thus usually preferred over the historic P/E.
The CAPE P/E (‘Cyclically Adjusted Price/Earnings) or Shiller-PE (after Robert J. Shiller, an American economist) tries to ‘smoothen’ the often highly volatile price-earnings ratio over the business cycle.
Imagine a company in a cyclical industry such as chemicals with low profit margins. Such a company might trade at a very low P/E during a boom cycle (when they are making big profits) and subsequently, turn into a loss-making company in a recession.
By using the Shiller or CAPE P/E, one can identify if a company or the whole market (this metric is mainly used when looking at Indices such as the S&P 500) is cheap or expensive in comparison with periods in the past.
The ratio uses the average of earnings-per-share over the past 10 years (that’s why it is also called P/E 10) in the denominator and the current stock or index price in the numerator.
If the S&P 500 is trading at 4,800 points and the average of each component’s earnings per share over the past 10 years is 24, the CAPE P/E is 20.
Note: again, the CAPE PE can be subject to look-ahead bias if for example high-growth (and expensive on P/E basis) companies are replacing cheap companies over time. This effect seems to have contributed to rising CAPE PEs the the S&P 500 over the past years.