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 Multiple 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.
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 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 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 Valuations
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 Charts.
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 Flow 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?
- 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
- Likewise, if you look at the Average Forward PE Multiple, company BBB has lower Forward Price Earning Ratio 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 Ratio is more than the Average Trailing PE Ratio. 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 Ratio (all are closer to Trailing PE of 23x
- Let us now compare the Forward PE 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)
- 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 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 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 it is 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 Price = 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 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 –
Additionally, if you want to look at the various PE Multiples of different countries, you can look at the following resources –
Rationale for using PE Ratio
- PE Multiple is the most commonly used equity multiple. 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 policies.
- Efforts 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 Ratio, Current Ratios, and Acid Test Ratio, etc are not taken into account
- Cash Flows are not taken into account. Cash Flows from Operations, Cash Flow from investment and Cash Flow from financing are not reflected in this Price Earning Ratio.
- Different debt to equity 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. For example, 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 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 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/EBITDA 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 the 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
Hope you enjoyed this article. Good Luck!
