PE Ratio

What is PE Ratio?

Price to earnings ratio (P/E) is one of the most important financial analysis ratios that is used by analysts to determine how the company is faring when compared to other companies in the same domain and how the company is faring when compared to the past performance of the company.

PE Formula

PE ratio (price to earnings) is primarily derived from the Payback MultiplePayback MultipleThe payback period refers to the time that a project or investment takes to compensate for its total initial cost. In other words, it is the duration an investment or project requires to attain the break-even point.read more that 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 multiple 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 Share

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For eg:
Source: PE Ratio (wallstreetmojo.com)

On Feb 2, Google passed Apple as the most valuable company – Google Market Capitalization surpassed Apple Market Cap. How did this happen?  Let us closely look at there this price earning ratio example –  Google PE ratio is trading at 30.58x; however, Apple Price Earning Ratio was at around 10.20x.

source: ycharts

Despite the lower PE multiple 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.

source: ycharts

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 Ratio or Trailing PE Ratio?
• Why are Apple prices decreasing even though it has a lower PE Ratio?

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 multiple or Price Earning Ratio.

Also, checkout Why Price to Book Value is used for Bank ValuationsWhy Price To Book Value Is Used For Bank ValuationsPrice to Book Value Ratio or P/B Ratio helps to identify stock opportunities in Financial companies, especially banks, and is used with other valuation tools like PE Ratio, PCF, EV/EBITDA. Price to Book Value Ratio = Price Per Share / Book Value Per Share read more.

This Price to Earning Guide focuses on the nuts and bolts of PE multiple and covers the following topics.

• PE Ratio Calculations
• How to PE for Valuations?
• Finding Target Price using PE Ratio
• Industry and Country Wise PE Multiples
• Rationale for using PE Ratio
• Limitations of PE Ratio

Price Earning Ratio Calculation

Let us take a quick PE Ratio example of Colgate and calculate its PE multiple.

As of Feb 22, 2016, Colgate Price Per Share is $67.61

Colgate’s earnings per share (trailing twelve months) is 1.509

Price Earning Ratio or PE Ratio Formula = $67.61/1.509 = 44.8x

Simple, as you saw that it is not at all difficult to calculate PE ratio :-)

PE Ratio Examples

Method #1 Compare Historical Price Earning Ratio of the Company

Graphical Interpretation of PE Multiple is no rocket science. If you are wondering how to create this Price Earning Ratio graph, you can look at the Investment Banking ChartsInvestment Banking ChartsThe top 4 investment banking charts an investment banking firm must be aware of while creating excellent financial and valuation models and its analysis include PE chart, PE band chart, football field graph and scenario graph. read more.

Price Earning Ratio chart helps the investors visualize the valuation multiple of Stock or Index over a period of time. In this  Price Earning Ratio example 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 Price Earning Ratio Ratios. We note that the above graph denotes that stock is overvalued as compared to historical PE multiple.

Likewise, from the above Price Earning Ratio Band Chart, we note that the stock is trading at the Upper Price Earning Ratio Band of 20.2x, implying higher valuations as compared to historical ratios.

You can prepare the same graphs for Price to Cash FlowPrice To Cash FlowPrice to Cash Flow Ratio is a value indicator that measures a company's stock price in relation to the cash flow amount it generates. This is determined as the ratio of Price Per Share to Operating Cash Flow Per Share. read more Ratio, EV to EBIT formula, etc.

Method # 2 – Compare the Price Earning Ratio of the company with the other companies within the sector.

Let us look at the PE multiple of Colgate and its comparison with the Industry. What do you note?

Source – Reuters

We note that Colgate’s Price Earning Ratio is 44.55x; however, the Industry Price Earning Ratio 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 Multiple (as this is a PE multiple 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?

I hope you found the answers; guess should not be too difficult. Let us dive into the rationale for the same.

Which is the cheapest stock?

1. The average Trailing Price Earning Ratio is 19.2x. There is only one stock that is lower than this average Trailing Price Earnings Ratio, i.e., Company BBB.
2. Likewise, if you look at the Average Forward PE Multiple, company BBB has a lower Forward Price Earning Ratio that its respective averages.
3. Strictly from this Comp Table, we note that Company BBB is the cheapest Stock.

Which is the Most Expensive Stock?

1. There are 3 stocks whose Trailing PE Ratio is more than the Average Trailing PE Ratio. Company AAA, CCC, and DDD
2. Out of these 3, it is difficult to find the most expensive stock strictly on the basis of Trailing PE Ratio (all are closer to Trailing PE of  23x
3. Let us now compare the Forward PEForward PEForward PE ratio uses the forecasted earnings per share of the company over the next 12 months for calculating the price-earnings ratio. Forward PE ratio formula = Price per share/Projected earnings per share read more Ratio of these 3 stocks. We note that for 2016, Stock DDD has the highest Forward PE Ratio (28.7x in 2016E and 38.3x in 2017E)
4. This implies that Stock DDD is the most expensive stock from the above table.

Though the Price Earning Ratio formula is easy to calculate, one should keep in mind the following important points regarding the PE Multiple.

• The two companies may have different growth prospects.
• The quality of earningsQuality Of EarningsQuality of earnings refers to the income generated from the business's core operations (recurring) and does not include the one-off revenues (nonrecurring) generated from other sources. Quality evaluation helps the financial statement users to make judgments about the "certainty" of current income and the future possibilities.read more 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 Multiple 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 multiple should not necessarily prevent investors from investing in the stock.

How to Find Target Price using Price Earning Ratio?

Not only is it important for us to understand whether the stock is a BUY or a SELL, but it is also 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 PE Ratio 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 Ratio is 56.5x, and the Forward PE Ratios are 47.9x and 43.2x, respectively.

WallStreetMojo’s Target PriceTarget PricePrice Target in the context of stock markets, means the expected valuation of a stock in the coming future and the valuation may be done either by the stock analysts or by the investors themselves. For an investor, price target reflects the price at which he will be willing to buy or sell the stock at a particular period of time or mark an exit from their current position.read more = EPS (WallStreetMojo ) x Forward PE Ratio

Let us assume that  WallStreetMojo  2016E and 2017E EPS is $4 and $5, respectively.

Given the PE multiple 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!

Why?

Target prices look all wrong due to the presence of outliers in the Comparable Table that we prepared. Please note that HHH has Price Earning Ratio closer to 200x. There could be various reasons for the high Price Earning Ratio 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 multiple. Using these modified PE Multiples, 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 Price Earning Ratio

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 –

• Damodaran’s Website
• Yahoo Ratios

Additionally, if you want to look at the various PE Multiples of different countries, you can look at the following resources –

• Yardeni Research

Rationale for using PE Ratio

• PE Multiple is the most commonly used equity multipleEquity MultipleEquity multiple refers to the growth potential of an asset or investment measured in the number of times the current value is of the initial investment. It is computed as the present value of a property divided by the amount invested.read more. The reason for this is its 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 Valuation Technique, this PE Multiple based valuation approach is not sensitive to assumptions. In DCF, change in WACC or growth rate assumptions can dramatically change the valuations.
• It can be used for comparison of companies within sectors and markets that have similar accounting policiesAccounting PoliciesAccounting policies refer to the framework or procedure followed by the management for bookkeeping and preparation of the financial statements. It involves accounting methods and practices determined at the corporate level.read more.
• The effort required is relatively less. A typical DCF model may take 10-15 days of the analyst’s time. However, a comparable PE comp can be prepared in a matter of hours.

Limitations

• Balance Sheet Risk is not taken into account. This implies that the fundamental position of the company is not reflected correctly in PE Multiple. For example, Cash RatioCash RatioCash Ratio is calculated by dividing the total cash and the cash equivalents of the company by total current liabilities. It indicates how quickly a business can pay off its short term liabilities using the non-current assets.read more, Current Ratios, and Acid Test Ratio, etc. are not taken into account
• Cash FlowsCash FlowsCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more are not taken into account. Cash Flows from OperationsCash Flows From OperationsCash flow from Operations is the first of the three parts of the cash flow statement that shows the cash inflows and outflows from core operating business in an accounting year. Operating Activities includes cash received from Sales, cash expenses paid for direct costs as well as payment is done for funding working capital.read more, Cash Flow from investment, Cash Flow From Investment, Cash flow from investing activities refer to the money acquired or spent on the purchase or disposal of the fixed assets (both tangible and intangible) for the business purpose. For instance, the purchase of land and joint venture investment is cash outflow, while equipment sale is a cash inflow.read moreand Cash Flow from financing are not reflected in this Price Earning Ratio.
• Different debt to equityDebt To EquityThe debt to equity ratio is a representation of the company's capital structure that determines the proportion of external liabilities to the shareholders' equity. It helps the investors determine the organization's leverage position and risk level. read more structure can have a significant effect on the company’s earnings. Earnings can vary widely for companies that have debt due to a component of Interest Payments affecting the Earnings Per Share.
• It cannot be used when earnings are negative. E.g., Box Inc. You cannot simply find PE Multiple 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 management. Let us take a quick look at this PE ratio 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 everything 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 the same.

Introducing a slight twist now. Assuming that AA follows Straight Line Depreciation Policy and BB follows an accelerated depreciation policy. This is the only change between the two companies. Straight-line charges equal depreciation 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 Multiple of AA is 22.9x, while the PE PE Multiple of BB is 38.1x. So which one will you buy? Given this information, we are inclined to favor AA as its PE multiple is lower. However, our very assumption that these two companies are identical twins and should command the same valuations is challenged because we used PE Multiple. We can use other ratios like EV/EBITDARatios Like EV/EBITDAEV to EBITDA is the ratio between enterprise value and earnings before interest, taxes, depreciation, and amortization that helps the investor in the valuation of the company at a very subtle level by allowing the investor to compare a specific company to the peer company in the industry as a whole, or other comparative industries.read more to solve such issues; however, we will come to that discussion in another post. For the moment, please note that PE ratios have some serious limitations in its universal application.

For a reason above, it is also recommended to use earnings as earnings before exceptional items.

Conclusion

PE Ratios remain one of the widely used Valuation methodologies. On one side, the Price Earning Ratio is very easy to calculate and understand; however, its application can be very complex and most tricky. Please be careful while considering Price Earning Ratio and do consider not only just the Trailing PE ratio but also the Forward PE Ratios to find the appropriate Target Price.

PE Ratio Video

I hope you enjoyed this article. Good Luck!

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