When it comes to valuing stocks, the price-to-earnings (P/E) ratio is the number one metric for investors that want an instant fix on what the market thinks of a company. But while the beloved P/E can tell you a lot about a share price there are health warnings to heed if you don’t want to be left exposed by its limitations.
What is the P/E ratio?
The price/earnings, P/E or ‘multiple’ as it is sometimes called compares a company’s stock price with its historic EPS, or earnings per share (which you’ll find on many websites or ideally in the company’s P&L statement). It is effectively a shorthand for how expensive or cheap a share is compared with its profits. Alternatively, it can be calculated by dividing the company’s market capitalisation by its total annual earnings.
As an example, online fashion retailer ASOS (LON:ASC) last year delivered a normalised EPS of 25.6p and saw its shares close on January 23rd at 1757p. By dividing those figures you arrive at a current P/E of 68. By comparison, stalwart high street retailer Marks And Spencer (LON:MKS) trades on a P/E of 8.8, while the FTSE All Share as a whole trades on a P/E of around 11.
While these ratios are generally calculated on the basis of historic earnings, it is worth noting that there are variations in the formula for arriving at P/E which can make comparison across different sources dangerous. At times you will see the stock price divided by the forecast EPS as a way of producing a ‘predicted’ P/E ratio using analysts’ expectations as a guide. Other times, the EPS figure will be produced from past two quarters and the forecast two quarters in order to smooth out the lag between annual results – this is known as the ‘rolling’ P/E and is the approach we typically use with Stockopedia PRO.
Another complication is that P/E ratios may be based on either reported earnings (i.e. exactly as per the company’s annual report) or normalised earnings (i.e. with adjustments for exceptional or non-recurring items). We use normalised earnings as we believe it makes for much more meaningful comparisons between companies.
What the P/E tells you
The P/E is a measure of how highly valued the company's earnings are in the market. So firstly it tells you what an investor is prepared to pay for every £1 of those earnings and secondly, how many years an investor would have to wait to get back his investment through current earnings (assuming all earnings are paid out as dividends, which would be somewhat unusual of course!). In essence, the P/E tells us the degree of confidence that investors have in the future of the business. A low P/E ratio of, say, 3 or 5 would show very little confidence in the sustainability of that business whereas a much higher P/E of 30+ expresses a great deal of optimism about the future of a business.
In the case of value investors, they are very focused on buying stocks that are trading at very low P/Es, believing that this represents a bargain (especially if the PE is low compared to historic averages). In the case of growth investors, the P/E is seen as less meaningful since they hope that current earnings will soon multiply.
If we look at ASOS, an investor buying shares on January 23rd was theoretically prepared to wait 68.7 years before recouping his investment, at least based on current earnings. That’s of course a somewhat absurd comparison since ASOS is growing rapidly – the point is that the P/E on its own makes no allowance for growth prospects. Investors that want to adjust the PE to take account of growth forecasts should refer to the price-earnings growth ratio, or the PEG, which is espoused by famous investors Jim Slater and Peter Lynch.
Shares in ASOS have quadrupled in two years and the market appears to think there is more growth to come – and its P/E shows that investors are paying a premium for that sentiment. Meanwhile, over the same period, shares in M&S have seen short periods of growth but are currently trading broadly where they were two years ago – which is partly the reason why its P/E is more modest.
Academic research has found that all other things being equal, shares on a low P/E ratio outperform those on a high P/E ratio over the long term ('the value effect') and low PE investing is central to the thinking of legendary investors like Benjamin Graham and John Neff. But in the short term, and especially in bull market runs, high P/E ‘glamour’ stocks have the ability to outperform low P/E ‘value’ stocks.
Where the P/E falls down
Despite being a byword for valuation, P/E has its detractors and many of them have a gripe about the use of earnings as an indicator. Unlike other metrics such as cash flow and dividends, earnings can be subject to manipulation at company level, which means P/E can be distorted depending on how the company has accounted for particular items (see a discussion of the Accrual Anomaly here). The fact that accounting standards vary from country to country only adds to that problem.
As an example, Warren Buffett instead judges performance using "owner earnings", which he argues reflects the true cash flow generation of a company. This is defined as net income plus non-cash charges of depreciation and amortization less capital expenditures and any additional working capital that might be needed (effectively “free cash flow”).
If using earnings as a single indicator of a company’s profitability is risky then using P/E as an indicator for valuation is perilous without taking other metrics into consideration. For example, a low P/E could reflect market expectations that bad news is on the way – meaning that an apparently attractively priced stock could suddenly become a basket case. Equally, a high P/E ratio may indicate that the market has recognised the future earnings potential of a company and has priced it accordingly. If that company slips up, the investor is at risk of seeing the value tumble as market enthusiasm evaporates. So, without comparing the P/E of a company with, say, its history, its sector or the market as a whole, the ratio can be misinterpreted or rendered utterly meaningless. As a result, investors will often use it to measure a company against its peers and use the P/E of an overall sector as a benchmark.
Meanwhile, for investors in small cap stocks, and particularly those companies involved in natural resources, the use of P/E in forming an opinion on the share value is particularly troublesome. For stocks with little or no earnings history (yet possibly boasting substantial asset bases and/or other upside potential), the P/E is likely to be non-existent or otherwise useless. As a result, in the case of junior oil & gas and mining companies, P/E is usually ditched as a measure of value in favour of metrics such as net asset value, independent reports and the management’s track record.
A final weakness is that, by focusing on price / market capitalisation, the P/E also ignores the impact of debt – for that reason, it is arguably inferior to measures like Entreprise Value (EV) to EBITDA or EV/Free Cash Flow. These measures are widely used by professional investors as - unlike the P/E - they are neutral to the capital structure of the company in question (i.e. they are not distorted by leverage).
The value of P/E
P/E offers investors a straightforward formula for valuing a stock and, as a result, it is frequently found in the stock-buying strategies of some of the world’s most successful investors. Critics have bemoaned its inability to take account of growth and the fact that, on its own, the P/E has limited meaning. However, if investors take account of the known risks, the ratio offers an important valuation and benchmarking tool.
Filed Under: Value Investing,