Price–earnings ratio

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Robert Shiller's plot of the S&P composite real price–earnings ratio and interest rates (1871–2012), from Irrational Exuberance, 2d ed.[1] In the preface to this edition, Shiller warns that "the stock market has not come down to historical levels: the price–earnings ratio as I define it in this book is still, at this writing [2005], in the mid-20s, far higher than the historical average. ... People still place too much confidence in the markets and have too strong a belief that paying attention to the gyrations in their investments will someday make them rich, and so they do not make conservative preparations for possible bad outcomes."

The price-to-earnings ratio, or P/E ratio, is an equity valuation multiple. It is defined as market price per share divided by annual earnings per share.[2]

Versions[edit]

There are multiple versions of the P/E ratio, depending on whether earnings are projected or realized, and the type of earnings.

  • "Trailing P/E" uses net income for the most recent 12 month period, divided by the weighted average number of common shares in issue during the period. This is the most common meaning of "P/E" if no other qualifier is specified. Monthly earnings data for individual companies are not available, and in any case usually fluctuate seasonally, so the previous four quarterly earnings reports are used and earnings per share are updated quarterly. Note, each company chooses its own financial year so the timing of updates varies from one to another.
  • "Trailing P/E from continued operations" uses operating earnings, which exclude earnings from discontinued operations, extraordinary items (e.g. one-off windfalls and write-downs), and accounting changes.
  • "Forward P/E": Instead of net income, this uses estimated net earnings over next 12 months. Estimates are typically derived as the mean of those published by a select group of analysts (selection criteria are rarely cited).

As an example, if stock A is trading at $24 and the earnings per share for the most recent 12-month period is $3, then stock A has a P/E ratio of 24/3 or 8. Put another way, the purchaser of the stock is paying $8 for every dollar of earnings. Companies with losses (negative earnings) or no profit have an undefined P/E ratio (usually shown as "not applicable" or "N/A"); sometimes, however, a negative P/E ratio may be shown.

Some people mistakenly use the formula market capitalization / net income to calculate the P/E ratio. This formula often gives the same answer as market price / earnings per share, but if new capital has been issued it gives the wrong answer, as market capitalization = market price × current number of shares whereas earnings per share= net income / weighted average number of shares.

Variations on the standard trailing and forward P/E ratios are common. Generally, alternative P/E measures substitute different measures of earnings, such as rolling averages over longer periods of time (to attempt to "smooth" volatile or cyclical earnings, for example),[3] or "corrected" earnings figures that exclude certain extraordinary events or one-off gains or losses. The definitions may not be standardized. For companies that are loss-making, or whose earnings are expected to change dramatically, a "primary" P/E can be used instead, based on the earnings projections made for the next years to which a discount calculation is applied.

Interpretation[edit]

By comparing price and earnings per share for a company, one can analyze the market's stock valuation of a company and its shares relative to the income the company is actually generating. Stocks with higher (or more certain) forecast earnings growth usually have a higher P/E, and those expected to have lower (or riskier) earnings growth usually have a lower P/E. Investors can use the P/E ratio to compare the value of stocks: if one stock has a P/E twice that of another stock, all things being equal (especially the earnings growth rate), it is a less attractive investment.[citation needed] Companies are rarely equal, however, and comparisons between industries, companies, and time periods may be misleading. P/E ratio in general is useful for comparing valuation of peer companies in similar sector or group.

Another helpful perspective holds that the P/E ratio is much the same as an expression of the unit cost of any commodity, such as coffee or gasoline. For those items, a pound or a gallon are the respective units. For a share of stock, a dollar's worth of earnings is the unit of choice. A purchaser knows, from experience, what a pound of coffee or a gallon of gas usually costs. So she can tell from her experience whether a current price is reasonable. Similarly, a prudent fundamental investor can tell, from the historical range of high and low P/E ratios, whether or not a current P/E ratio is a reasonable price to pay for a dollar's worth of a company's earnings.

Since fundamental investors acknowledge that, over the long term, the price paid for a share of stock is generally proportionate to the underlying company's earnings per share, the median of high and low P/E ratios over a period of at least five years may be used as a proxy for a reasonable P/E ratio. This metric is sometimes referred to as a company's signature P/E.[4]

Various interpretations of a particular P/E ratio are possible, and the historical table below is just indicative and cannot be a guide, as current P/E ratios should be compared to current real interest rates (see Fed model):

  N/A   A company with no earnings has an undefined P/E ratio. By convention, companies with losses (negative earnings) are usually treated as having an undefined P/E ratio, even though a negative P/E ratio can be mathematically determined.
0–10 Either the stock is undervalued, or the company's earnings are thought to be in decline. Alternatively, current earnings may be substantially above historic trends or the company may have profited from selling assets.
10–17 For many companies a P/E ratio in this range may be considered fair value.
17–25 Either the stock is overvalued or the company's earnings have increased since the last earnings figure was published. The stock may also be a growth stock with earnings expected to increase substantially in the future.
25+ A company whose shares have a very high P/E may have high expected future growth in earnings, or this year's earnings may be considered exceptionally low, or the stock may be the subject of a speculative bubble.

It is usually not enough to look at the P/E ratio of one company and determine its status. Usually, an analyst looks at a company's P/E ratio compared to the industry the company is in, the sector the company is in, as well as the overall market (for example the S&P 500 if it is listed in a US exchange). Sites such as Reuters offer these comparisons in one table.[5] Often, comparisons will also be made between quarterly and annual data. Only after a comparison with the industry, sector, and market can an analyst determine whether a P/E ratio is high or low with the above mentioned distinctions (i.e., undervaluation, over valuation, fair valuation, etc.).

Using discounted cash flow analysis, the impact of earnings growth and inflation can be evaluated. Using constant historical earnings growth rate of 3.8 and post-war S&P 500 returns of 11% (including 4% inflation) as the discount rate, the fair P/E is obtained as 14.42. A stock growing at 10% for next five years would have a fair P/E of 18.65.

Effect of leverage[edit]

Example—effect of leverage on the PE ratio

P/E ratios are highly dependent on capital structure. Leverage (i.e. debt taken on by the company) affects both earnings and share price in a variety of ways, including the leveraging of earnings growth rates, tax effects and impacts on the risk of bankruptcy, and can sometimes dramatically affect the company's results. For example, for two companies with identical operations and taxation regime, and trading at typical P/E ratios, the company with a moderate amount of debt commonly has a lower P/E than the one with no debt, despite having a slightly higher risk profile, slightly more volatile earnings and (if earnings are increasing) a slightly higher earnings growth rate.

At higher levels of leverage (where the risk of bankruptcy forces up debt costs) or if profits decline substantially (driving up the P/E ratio) the indebted firm has a higher P/E ratio than an unleveraged firm.

To try to eliminate these leverage effects and better compare the values of the underlying operating assets, it is often preferable to use multiples based on the enterprise value of a company, such as EV/EBITDA, EV/EBIT or EV/NOPAT.

Historical P/E ratios for the US stock market[edit]

Price-Earnings ratios as a predictor of twenty-year returns based upon the plot by Robert Shiller (Figure 10.1,[1] source). The horizontal axis shows the real price-earnings ratio of the S&P Composite Stock Price Index as computed in Irrational Exuberance (inflation adjusted price divided by the prior ten-year mean of inflation-adjusted earnings). The vertical axis shows the geometric average real annual return on investing in the S&P Composite Stock Price Index, reinvesting dividends, and selling twenty years later. Data from different twenty-year periods is color-coded as shown in the key. See also ten-year returns. Shiller stated in 2005 that this plot "confirms that long-term investors—investors who commit their money to an investment for ten full years—did do well when prices were low relative to earnings at the beginning of the ten years. Long-term investors would be well advised, individually, to lower their exposure to the stock market when it is high, as it has been recently, and get into the market when it is low."[1]

Since 1900, the average P/E ratio for the S&P 500 index has ranged from 4.78 in Dec 1920 to 44.20 in Dec 1999,.[6] However, except for some brief periods, during 1920–1990 the market P/E ratio was mostly between 10 and 20.[7]

The average P/E of the market varies in relation with, among other factors, expected growth of earnings, expected stability of earnings, expected inflation, and yields of competing investments. For example, when US treasury bonds yield high returns, investors pay less for a given earnings per share and P/E's fall.

The average US equity P/E ratio from 1900 to 2005 is 14 (or 16, depending on whether the geometric mean or the arithmetic mean, respectively, is used to average).[citation needed]

Jeremy Siegel has suggested that the average P/E ratio of about 15 [8] (or earnings yield of about 6.6%) arises due to the long term returns for stocks of about 6.8%. In Stocks for the Long Run, (2002 edition) he had argued that with favorable developments like the lower capital gains tax rates and transaction costs, P/E ratio in "low twenties" is sustainable, despite being higher than the historic average.[9]

S&P 500 index and price-to-earnings ratios.svg

Set out below are the recent year end values of the S&P 500 index and the associated P/E as reported.[10] For a list of recent contractions (recessions) and expansions see US Business Cycle Expansions and Contractions.

Date Index P/E EPS growth % Comment
2009-06-30 919.32 122.41
2009-03-31 797.87 116.31
2008-12-31 903.25 60.70
2007-12-31 1468.36 22.19 1.4
2006-12-31 1418.30 17.40 14.7
2005-12-31 1248.29 17.85 13.0
2004-12-31 1211.92 20.70 23.8
2003-12-31 1111.92 22.81 18.8
2002-12-31 879.82 31.89 18.5
2001-12-31 1148.08 46.50 −30.8 2001 contraction resulting in P/E peak
2000-12-31 1320.28 26.41 8.6 Dot-com bubble burst: 10 March 2000
1999-12-31 1469.25 30.50 16.7
1998-12-31 1229.23 32.60 0.6
1997-12-31 970.43 24.43 8.3
1996-12-31 740.74 19.13 7.3
1995-12-31 615.93 18.14 18.7
1994-12-31 459.27 15.01 18.0 Low P/E due to high recent earnings growth.
1993-12-31 466.45 21.31 28.9
1992-12-31 435.71 22.82 8.1
1991-12-31 417.09 26.12 −14.8
1990-12-31 330.22 15.47 −6.9 July 1990 – March 1991 contraction.
1989-12-31 353.40 15.45 .
1988-12-31 277.72 11.69 . Bottom (Black Monday was 19 Oct 1987)

Note that at the height of the Dot-com bubble P/E had risen to 32. The collapse in earnings caused P/E to rise to 46.50 in 2001. It has declined to a more sustainable region of 17. Its decline in recent years has been due to higher earnings growth.

The P/E ratio in business culture[edit]

The P/E ratio of a company is a major focus for many managers. They are usually paid in company stock or options on their company's stock (a form of payment that is supposed to align the interests of management with the interests of other stock holders). The stock price can increase in one of two ways: either through improved earnings or through an improved multiple that the market assigns to those earnings. In turn, the primary drivers for multiples such as the P/E ratio is through higher and more sustained earnings growth rates.

Consequently, managers have strong incentives to boost earnings per share, even in the short term, and/or improve long term growth rates. This can influence business decisions in several ways:

  • If a company wants to acquire companies with a higher P/E ratio than its own, it usually prefers paying in cash or debt rather than in stock. Though in theory the method of payment makes no difference to value, doing it this way offsets or avoids earnings dilution (see accretion/dilution analysis).
  • Conversely, companies with higher P/E ratios than their targets are more tempted to use their stock to pay for acquisitions.
  • Companies with high P/E ratios but volatile earnings may be tempted to find ways to smooth earnings and diversify risk—this is the theory behind building conglomerates.
  • Conversely, companies with low P/E ratios may be tempted to acquire small high growth businesses in an effort to "rebrand" their portfolio of activities and burnish their image as growth stocks and thus obtain a higher PE rating.
  • Companies try to smooth earnings, for example by "slush fund accounting" (hiding excess earnings in good years to cover for losses in lean years). Such measures are designed to create the image that the company always slowly but steadily increases profits, with the goal to increase the P/E ratio.
  • Companies with low P/E ratios are usually more open to leveraging their balance sheet. As seen above, this mechanically lowers the P/E ratio, which means the company looks cheaper than it did before leverage, and also improves earnings growth rates. Both of these factors help drive up the share price.
  • Strictly speaking, the ratio is measured in years, since the price is measured in dollars and earnings are measured in dollars per year. Therefore, the ratio demonstrates how many years it takes to cover the price, if earnings stay the same.

Related measures[edit]

See also[edit]

References[edit]

  1. ^ a b c Shiller, Robert (2005). Irrational Exuberance (2d ed.). Princeton University Press. ISBN 0-691-12335-7. 
  2. ^ "Price-Earnings Ratio (P/E Ratio)". Investopedia. Retrieved 31 December 2007. 
  3. ^ Anderson, K.; Brooks, C. (2006). The Long-Term Price-Earnings Ratio. 
  4. ^ Ellis Traub, Take Stock: A Roadmap to Profiting from your First Walk Down Wall Street, 3rd ed. StockCentral Books, 2010, 63,64
  5. ^ Example of SPY. Reuters.
  6. ^ "Seeking Alpha blog comment...". 
  7. ^ Is the P/E Ratio a Good Market-Timing Indicator?
  8. ^ "Is the S&P 500 Index now over-valued? What Return Can You Reasonably Expect From Investing in the S&P 500 Index?". investorsfriend.com. Retrieved 18 December 2010. 
  9. ^ NAREIT – Capital Markets
  10. ^ "S&P 500 Earnings and Estimate Report". 

External links[edit]