PE Ratio – On 2nd Feb, Google passed Apple as the most valuable company – Google Market Capitalization surpassed Apple Market Cap. How did this happen? Let us closely look at their respective PE ratios, Google PE ratio is trading at 30.58x, however, Apple PE was at around 10.20x.
Despite of lower PE ratio of Apple, Apple stocks still have taken the beating. Apple returned -25.8% (negative) in the past 1 year, however, Google Returned approx. 30% (positive) in the corresponding period.
A couple of quick questions on this for you?
- Is Apple a BUY?
- Is Google a SELL?
- Is Apple now cheaper than Google?
- Which PE are we talking about – Forward PE or Trailing PE?
- Why Apple prices are decreasing even though it has a lower PE?
To understand the answer to all the questions above, it is important for us to understand the core and probably the most important valuation parameter i.e. PE Ratio or Price Earnings Ratio.
Also, checkout Why Price to Book Value is used for Bank Valuations
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This tutorial focus on the nuts and blots of PE multiple and covers the following topics
- What is PE Ratio
- PE Ratio Calculations
- Trailing PE vs Forward PE
- How to PE for Valuations?
- Finding Target Price using PE Ratio
- Industry and Country Wise PE Multiples
- Rationale for using PE Multiple
- Limitations of PE Ratio
What is PE Ratio?
This ratio is primarily derived from the Payback Multiple. Payback means how many years it will take to get your money back. Likewise, think of PE as how many years’ earnings it will take for an investor to recover the price paid for the share.
For example, if the PE ratio is 10x. This basically implies that for each $1 of earning, the investor has paid $10. Hence, it will take 10 years of earnings for the investor to recover the price paid.
PE Ratio Formula = Price Per Share / Earnings Per
PE Ratio Calculation
Let us take a quick example of Colgate and calculate its PE ratio.
As of Feb 22, 2016, Colgate Price Per Share is $67.61
Colgate’s earnings per share (trailing twelve months) is 1.509
Price to Earnings or PE Ratio = $67.61/1.509 = 44.8x
Simple, as you saw that it is not at all difficult to calculate PE ratio 🙂
Trailing PE vs Forward PE
PE multiples that we saw earlier were all Historical or Trailing PE Ratios. Infact, there are two types of multiples – Trailing PE Multiple and Forward PE Multiple
Trailing PE Formula (TTM or Trailing Twelve Months) = Price Per Share / EPS over the previous 12 months.
PE Calculation of Colgate that we did was the Trailing PE.
Let us now look at what Forward PE Formula is –
Forward PE Formula = Price Per Share / Forecasted EPS over the next 12 months
As you can note from above, the key difference between the two is the forecasted EPS over the next 12 months.
Trailing PE use the Historical EPS, while Forward PE use the Forecast EPS.
Let us look at the above example to calculate the Trailing PE and Forward PE.
Company AAA, Trailing Twelve Months EPS is $10.0 and its Current Market Price is $234.
Trailing PE = $234 / $10 = $23.4x
Likewise, let us calculate the Forward Price to Earnings of Company AAA. Company AAA 2016 estimated EPS is $11.0 and its current price is $234.
Forward PE = $234 / $11 = $21.3x
Some of the things to consider regarding the Trailing PE vs Forward PE.
- If EPS is expected to grow then the Forward PE will be lower than the Historical or Trailing PE. From the above table, AAA and BBB show an increase in EPS and hence, their Forward PE are lower that the Trailing PE.
- On the other hand, if EPS is expected to decrease, then you will note that the Forward PE will be higher than the Trailing PE. This can be observed in Company DDD, whose Trailing PE was at 23.0x, however, Forward PE increased to 28.7x and 38.3x in 2016 and 2017, respectively,
- Please note that the Forward PE only factors forecast EPS (2016E, 2017E and so on), whereas the stock price will reflect earnings growth prospects far into the future.
- One should not only compare the Trailing PE for valuation comparison between the two companies, but also look at the Forward PE to focus on Relative Value – whether the PE differences reflect company’s long term growth prospects and financial stability.
A Quick Question on Trailing and Forward PE
Rudy Comp reported $32million in earnings during FY2015. An analyst forecasts an EPS over the next twelve month of $1.2. Rudy has 25 million shares outstanding at a market price of $20/share. Calculate Rudy’s trailing and leading P/E ratio. If the 5 year historical average PE is 15x, whether Rudy Comp is overvalued or undervalued?
Answer – Please drop your answers in the comment box.
Also, do checkout What is Enterprise Value vs Equity Value
How to use PE Ratio for valuations
Method #1 Compare Historical PE of the Company
Graphical Interpretation of PE Ratio Multiple is no rocket science. If you are wondering how to create this PE graph, you can look at the Investment Banking Charts.
PE chart helps the investors visualize the valuation multiple of Stock or Index over a period of time. For example, the below PE graph of a company named Foodland Farsi is depicted over a period of March’02 until March’07.
The above graph compares the current PE Multiple with the historical PE Ratios. We note that the above graph denotes that stock is overvalued as compared to historical PE ratios.
Likewise, from the above PE Band Chart, we note that the stock is trading at the Upper PE Band of 20.2x implying higher valuations as compared to historical ratios.
Method # 2 – Compare the PE of the company with the other companies within the sector.
Let us look at the PE ratio of Colgate and its comparison with the Industry. What do you note?
Source – Reuters
We note that Colgate’s PE is 44.55x, however the Industry PE is 61.99x. This implies that on one side Colgate is trading at approx. 44 times its earnings, the Industry is trading at approx. 62 times its earnings. This is a no-brainer; you would like to pay $44 per $ earnings for Colgate, rather than opting for $62 per $ earning for the Industry.
Method #3 – Interpretation using a Comparable Comp
The above table is nothing but a Comparable Comp. A comparable comp lists all relevant industry competitors, its financial forecasts and important valuation parameters. In this table, we have considered only PE multiples (as this is a PE ratio discussion).
A couple of questions for you with respect to the comp table provided above –
- Which is the cheapest stock?
- Which one is the most expensive?
Hope you found the answers, guess should not be too difficult. Let us dive into the rational for the same.
Which is the cheapest stock?
- Average Trailing PE is 19.2x. There is only one stock that is lower than this average Trailing PE i.e. Company BBB
- Likewise if you look at the Average Forward PE, company BBB has lower Forward PE that its respective averages
- Strictly from this Comp Table, we note that Company BBB is the cheapest Stock
Which is the Most Expensive Stock?
- There are 3 stocks whose Trailing PE is more than the Average Trailing PE. Company AAA, CCC and DDD
- Out of these 3, it is difficult to find the most expensive stock strictly on the basis of Trailing PE (all are closer to Trailing PE of 23x
- Let us now compare the Forward PE of these 3 stocks. We note that for 2016, Stock DDD has the highest Forward PE Multiple (28.7x in 2016E and 38.3x in 2017E)
- This implies that Stock DDD is the most expensive stock from the above table.
Though PE Ratio is very easy formula to calculate, one should keep in mind the following important points regarding the PE ratio.
- The two companies may have different growth prospects
- The quality of earnings may differ – i.e. one company’s earnings may be more volatile than the other’s
- The balance sheet strength of the two companies may be different
A high PE is sometimes cited as a reason for not buying a stock. However, fast-growing companies are typically associated with high PEs. Obviously, investing in fast-growing companies can be profitable. Therefore a high PE should not necessarily prevent investors investing in the stock.
How to Find Target Price using PE Multiple?
Not only it is important for us to understand whether the stock is a BUY or a SELL, it is equally important to understand the Target Price of the stock under consideration.
What is Target Price? – it is nothing but what you expect the stock price to be, say at the end of 2016 or 2017 etc.
Let us look at the following Company Example
Let us assume that WallStreetMojo is operating in Services Sector along with its peers – AAA, BBB, CCC, DDD, EEE, FFF, GGG, HHH.
In order to find the Target Price of WallStreetMojo , we should find the Average Trailing PE and the Forward PEs. We note that the Average Trailing PE is 56.5x and the Forward PE are 47.9x and 43.2x respectively.
WallStreetMojo ‘s Target Price = EPS (WallStreetMojo ) x Forward PE
Let us assume that WallStreetMojo 2016E and 2017E EPS is $4 and $5 respectively.
Given the formula above,
WallStreetMojo 2016E Target price = $4 x 47.9 = $191.6
WallStreetMojo 2016E Target price = $5 x 43.2 = $216
Theoretically the Target Prices look good. Practically the Target Prices look all wrong!
Target prices look all wrong due to the presence of outlier in the Comparable Table that we prepared. Please note that HHH has PE multiple closer to 200x. There could be various reasons of high PE multiple of HHH, however, we are here to find the appropriate target price for WallStreetMojo .
For finding the Correct Target Price, we need to remove outliers like HHH, revise the Comparable Table and find the new average PE mulitple. Using these modified PEs, we can re-calculate the Target Price.
Revised WallStreetMojo 2016E Target price = $4 x 17.2 = $68.8
Revised WallStreetMojo 2016E Target price = $5 x 18.2 = $91
Industry and Country PE Mulitples
If you do not have access to paid databases like Bloomberg, Factset, Factiva, then you can look at some of the free resources for such data –
Additionally, if you want to look at the various PE of different countries, you can look at the following resources –
- Global Stock Market Valuation Ratios
- Yardeni Research
Rationale for using PE Mulitples
- PE ratio is the most commonly used equity multiple. Reason for this is it’s Data availability. You can easily find both the historical earnings as well as forecast earnings. Some of the websites that you can refer to find these are Yahoo Finance or Reuters
- If you compare this with the Discounted Cash Flow approach, this PE based valuation approach is not sensitive to assumptions. In DCF, change in WACC or growth rates assumptions can dramatically change the valuations.
- Can be used for comparison of companies within sectors and markets that have similar accounting policies.
- Efforts required is relatively less. A typical DCF model may take 10-15 days of analyst’s time. However, a comparable PE comp can be prepared in matter of hours.
Limitations of PE Ratio
- Balance Sheet Risk is not taken into account. This implies that the fundamental position of the company is not reflected correctly in PE ratio. For example, Cash Ratio, Current Ratios etc are not taken into account
- Cash Flows are not taken into account. Cash Flows required for operations, investment and financing are not reflected in this PE Multiple.
- Different debt to equity structure can have significant affect on the company’s earnings. Earnings can vary widely for companies that have debt due to omponent of Interest Payments affecting the Earnings Per Share.
- Cannot be used when earnings are negative. For example, Box Inc. You cannot simply find PE ratio for such unprofitable companies. One must use normalized earnings or forward multiples in such cases.
- Earnings are subject to different accounting policies. It can be easily manipulated by the management. Let us take a quick look at this example below.
Assume that there are two companies – company AA and BB. Think of these companies as identical twins (i know it is not possible for companies :-), but for a moment in a blue sky scenario let’s assume this is so). Identical sales, costs, clients and almost every thing possible.
In such a case, you should not have any preference to buy a specific stock as the valuations of both the companies should be same.
Introducing slight twist now. Assuming that AA follows Straight Line Depreciation Policy and BB follows accelerated depreciation policy. This is the only change between the two companies. Straight line charges equal deprecation over the useful life. Accelerated Deprecation policy charges higher depreciation in initial years and lower depreciation in final years.
Let us see what happens to their valuations?
As noted above, the PE ratio of AA is 22.9x while PE ratio of BB is 38.1x. So which one will you buy. Given this information, we are inclined to favour AA as its PE muliple is lower. However, our very assumption that these two companies are identical twins and should command same valuations is challenged because we used PE Ratio. We can use other ratios like EV/EBITDA to solve such issues, however, we will come to that discussion in another post. For the moment, please note that PE ratios has some serious limitations in its universal application.
For the reason above, it is also recommended to use earnings as earnings before exceptional items.
PE Ratios remain one of the widely used Valuation methodology. On one side the PE ratio is very easy to calculate and understand, however, its application can be very complex and mostly tricky. Please be careful while considering PE ratios and do consider not only just the Trailing PE ratio but also the Forward PE Ratios to find the appropriate Target Price.
Hope you enjoyed this article. Good Luck!