 Personal Finance PowerPoint Presentation Price to Earnings or PE Ratio. Prepare to get financially fit by practicing personal finance. Most of this information comes from Investopedia Price to Earnings PE Ratio, which you can find online. Take a look at the references, resources, continue your research from there. This by Jason Fernando. Update of July 14, 2022 in prior presentations. We've been taking a look at investment goals, investment strategies, investment tools, keeping in mind the two major categories of investments. That being fixed income, typically bonds, and the equities, typically the common stock. We're focused more here on the equity side of things. Also, keep in mind your investment tools and strategies. For example, if investing for retirement, you may be using tools such as mutual funds, such as ETFs, where you're pooling the money together in an attempt to diversify, possibly in these cases, not focusing so much on individual stocks, but sectors possibly looking more at indexes, for example. If you're trading individual stocks, then you're going to be wanting to drill down on those financial statements, doing some ratio analysis, and the price earnings ratio is one of the key components to be looking at. So what is the price earnings PE ratio? The price to earnings ratio is the ratio for valuing a company that measures its current share price relative to its earnings per share, the EPS. The price to earnings ratio is also sometimes known as the price multiple or the earnings multiple. So these ratios, of course, are going to be quite important when we want to be comparing things. Remember that this is applicable for many different areas, and your job performance, for example, you're probably going to run into situations where people are going to have to use some ratio analysis to see how well you're doing. And if we measure job performance of, say, athletes, for example, this is often what we are doing, helps us to do some comparisons in ways that we couldn't do without the ratios. So the PE ratios are used by investors and analysts to determine the relative value of a company's shares in an apples to apple comparison. So we want to be breaking things down so we can be comparing across different companies, looking at value, trying to determine if the price is appropriate and so on for our investment decisions. And we need to do so such a way that we have the same thing compared to the same thing, apples to apples, as they say. It can also be used to compare a company against its own historical record or to compare aggregate markets against one another or over time. So we can compare it to other companies, markets or industries in general or to our own past history to look at the performance of the company itself over time. PE may be estimated on a trailing, backward looking or forward projected basis. So we might look at the actual data that has actually happened or we might try to say, hey, look, I want to make a decision at the margin at this point in time because I'm using it for future decision making purposes. So maybe I'll try to have a forward projection to calculate it. The PE ratio formula and calculation, the formula and calculation used for this process are as follows. The PE ratio market value per share, that's going to be the share price determined by the market, not by the company market supply and demand. Divided by the earnings per share. So we talked about calculating the earnings per share and prior presentations. Once we have the earnings per share, oftentimes the next step will be calculating the PE. So to determine the PE value, one must simply divide the current stock price by the earnings per share. So the current stock price, PE, can be found simply by plugging a stock ticker symbol into any finance website. And although this concrete value reflects that investors most currently pay for a stock, the earnings per share is a slightly more nebulous figure. So the stock price is determined by the stock market. And remember that the stocks are uniform in nature. So it's corporation separate legal entity breaking out ownership into equal units of stock, which are typically traded on the exchange because we're usually talking about publicly traded companies here. And so therefore, if another stock is trading, that's the same as this stock and it's got no differences, we can use the market to help determine what the price is. So that is a great, great tool. So earnings per share comes in two main varieties. TTM is a Wall Street acronym for trailing 12 months. This number signals the company's performance over the past 12 months. The second type of earnings per share is found in a company's earnings release, which often provides earnings per share guidance. This is the company's best educated guess of what it expects to earn in the future. Now notice the past earning per share data is kind of reliable in that it's based on actual data, the past history, what has actually happened. But again, what we're trying to do is kind of look toward the future oftentimes. So we might try to say I'd rather have a projection that's looking forward going from this point that might be more useful for my current time frame. But obviously we don't know exactly what the future is at this point. So this different version of earnings per share form the basis of a trailing and forward PE respectively. So understanding the PE ratio, price earnings ratio, the price to earnings ratio PE is one of the most widely used tools by which investors and analysts determine a stock's relative valuation. So it's a really important ratio. The PE ratio helps one determine whether a stock is overvalued or undervalued. That's the key of the game. By low sell high, that's my investment strategy and advice. A company's PE can also be benchmark against other stocks in the same industry or against a broader market such as the S&P 500. So we can be of course doing some comparisons with the PE ratio to other stocks and industries. And that's part of the point. Sometimes analysts are interested in long term valuation trends and consider the PE 10 or PE 30 measures which averaged the past 10 or 30 years of earnings respectively. These measures are often used when trying to gauge the overall value of a stock index such as the S&P 500 because these long term measures can compensate for changes in the business cycle. So in that case we're trying to get a better grasp of basically the long term trend and obviously within each sector there's cycles, within cycles, within cycles, right? There's going to be good times and bad times for particular companies, for particular sectors and so on for particular reasons. So the PE ratio of the S&P 500 has fluctuated from a low of around 5X in 1917 to over 120X in 2009 right before the financial crisis. The long term average PE for the S&P 500 is around 16X meaning that the stocks that make up the index collectively command a premium 16 times greater than their weighted average earnings. So the forward price to earnings. These two types of EPS earnings per share metrics factor into the most common types of PE ratios. We've got the forward PE and the trailing PE. A third and less common variation uses the sum of the last two actual quarters and estimates of the next two quarters. So we can kind of use a hybrid of the past two quarters and then try to figure out what we think is going to happen in the next two quarters with regards to the earnings side of things. So the forward or leading PE uses future earnings guidance rather than trailing figures, sometime called estimated price to earnings. This forward looking indicator is useful for comparing current earnings to future earnings and helps provide a clearer picture of what earnings will look like without changes and other accounting adjustments. However, there are inherent problems with the forward PE metric, namely companies could underestimate earnings in order to beat the estimated PE when the next quarters earnings are announced. Other companies may overstate the estimate and later adjust it going into their next earnings announcement. So in other words, whenever we're trying to figure out or think about what the revenue of a company is going to be in the future, that's going to be a difficult thing to do. And we can be dependent on management to some degree because they're going to try to give us an accurate number to some degree. But we can see the incentives that are given when you have projections by management out into the future because one objective is they don't want to miss their target because that's going to look bad if they say they're going to do something and then they miss it. So they might fudge the number or make a low ball estimate so they can clear the hurdle easily, making them look good. So that's one strategy that could be used. On the other hand, they don't really like also having low estimates. So you can imagine situations when they're trying to appear strong by overestimating the estimate possibly to generate value to get a bump in valuation and hoping that kind of sparks a spiral of a positive virtuous cycle. But in any case, furthermore, external analysis analysts may also provide estimates which may diverge from a company estimates created confusion. So you might have outside analysts saying, yeah, this is what I think about it based on the information I have. And now you've got to think, okay, who has the most accurate information about their predictions of the future? So note that these tools that we're using, they're all estimates. They're all tools. So we're trying to paint a picture with basically statistical tools as opposed to this is a hard line rule. And this is kind of difficult for people that learn accounting oftentimes because you try to say, well, there's going to be a hard line rule. This is the way you do it. This is what it is. But when you're looking at statistics and trying to predict what's happening in the future, really you want to gather as much data as you can possibly looking at it from multiple angles. So that you can then put together your best assumptions of what's going to happen. So we've got the trailing price to earnings. The trailing PE relies on past performance by dividing the current share price by the total earnings per share earnings over the past 12 months. It's the most popular PE metric because it's the most objective assuming the company reporting earnings accurately. So clearly if we take the past earnings, then at least those are accurate for the timeframe. We would like to have accurate future numbers, but we don't know what those are, right? So we might just use the actual last numbers because that's what actually happened unless they lied on hopefully we can depend on the financial statements. Some investors prefer to look at the trailing PE because they don't trust another individual's earnings estimate. So you're going to say, hey, look, that's great, even if it's management, but you're a little bit biased by telling me what you think is going to happen in the future. I'll just look at what happened in the past because I can have a little bit more confidence in that and then make my own estimates. But the trailing PE also has its share of shortcomings, namely that a company's past performance doesn't signal future behavior. So in other words, past performance may give you some indications of the trends and what's going on and so forth. But if things are changing rapidly, then it may not reflect what's happening. There could be substantial changes, but of course, nobody knows what exactly the effect of those substantial changes are going to happen in the future, even management until the future becomes the present. But in any case, investors should thus commit money based on future earnings power, not the past. The fact that the earnings per share number remains constant while the stock price fluctuates is also a problem. If a major company event drives the stock price significantly higher or lower, the trailing PE will be less reflective of those changes. The trailing PE ratio will change as the price of the company's stock moves because earnings are only released each quarter while stock trades day in and day out as a result. Some investors prefer the forward PE. So if the forward PE ratio is lower than the trailing PE ratio, it means analysts are expecting earnings to increase. If the forward PE is higher than the current PE, analysts expect them to decrease. So let's think about that real quick here. If we're taking our PE ratio that we're considering and we're thinking that the forward earnings here are going to be higher than they were in the prior earnings, that would mean that the forward PE would have a higher denominator, which would make the total PE go down. On the other hand, if the earnings that we're expecting in the future, the forward earnings, the future perspective earnings are expected to be lower, that would mean the denominator would be decreased and that would mean that the future PE or the forward PE would be higher in that instance. Okay, valuation from PE. Valuation from PE, the price to earnings ratio or PE is one of the most widely used stock analysis tools by which investors and analysts determine stock valuation. In addition to showing whether a company stock price is overvalued or undervalued, the PE can review how a stock's valuation compares to its industry group or a benchmark like the S&P 500. In essence, the price to earnings ratio indicates the dollar amount an investor can expect to invest in a company in order to receive one dollar of that company's earnings. So this is why the PE is sometimes referred to as the price multiple because it shows how much investors are willing to pay per dollar of earnings. If a company was currently trading at a PE multiple of 20X, the interpretation is that an investor is willing to pay $20 for one dollar of earnings. So in other words, if we put $20 for an investment, we of course are hoping for a return in the future. The return in the future will be dependent on the company generating revenue, but although the company is generating revenue, we may not get that revenue back in the form of just cash in the form of a dividend. So in other words, if we put the $20 down, we expect to get a return in the future either in the form of a dividend or possibly in the form of the company reinvesting the earnings that they have into something like equipment, for example, which they're going to use to generate more revenue in the future, which should increase the value of the stock price. So if we're investing $20 and we're comparing that to the earnings of the company, the earnings of the company will ultimately hopefully be the thing generating value for us to return for us in some way, shape or form into the future. Also note that this $1 return is representing basically a year, the return in a year because we're looking at an income statement over a year's time frame, for example. Okay, so the PE ratio helps investors determine the market value of a stock as compared to the company's earnings. In short, the PE price earnings ratio shows what the market is willing to pay today for a stock based on its past or future earnings. A high PE could mean that a stock's price is high relative to earnings and possibly overvalued. So if we look at the PE ratio, we've got the price up top, which is determined by the market, and then the earnings. If we've got a high PE ratio, that means that the price is quite high relative to the earnings. So the price is multiples of the earnings. So if we've got a lower PE ratio, then you'd think the better valuation all else basically equal because it's closer to basically the earnings. And of course, this PE ratio is something that you would need to then be comparing to other stocks within the sector and other indexes and so on and so forth to determine if you think the price is properly valued. That would be one of the major tools. So conversely, a low PE might indicate that the current stock price is low relative to earnings. So example of a PE ratio. As a historical example, let's calculate the PE ratio for Wal-Mart WMT as of February 3rd, 2021 when the company stock price closed at $139.55. The company's earnings per share for the fiscal year ending January 31st, 2021 was $4.75 according to the Wall Street Journal. Therefore, the PE ratio is going to be the $135.55 divided by the 4.75, which gives us 29.38, comparing companies using PE. So as an additional example, we can look at two financial companies to compare their PE ratios and see which is relatively over or undervalued. Obviously, all this stuff is kind of relative because we're trying to use these tools to compare them to where we should be investing. So we need to be comparing them in comparison to other companies in their sector and so on and so forth to indexes and whatnot. So Bank of America Corporation BAC closed out the year 2020 with the following stats. Stock price $30.31, diluted earnings per share $1.87, PE equals 16.21, which is the $30.31 divided by the 1.87 to get to the PE of the 16.21. In other words, Bank of America traded at roughly 6x, 6 times. So you can see, of course, if this is the price here, 30, and the earnings are going to be the 1.87 for the diluted earnings per share, then the price is 16 times, a little bit over 16 times the earnings per share. So in other words, Bank of America trades at roughly 6x, 6 times trailing earnings. However, the 16.21 price earnings multiple by itself isn't helpful unless you have something to compare it with such a stocks industry group. So clearly, again, everything is kind of relative here because we're trying to choose which would be the most valuable investment. So that's a benchmark index or Bank of America's historical PE ratio. So Bank of America's PE at 16x was slightly higher than the S&P 500. So now we're looking at one of the major indexes, the S&P 500, to see if they're kind of in the average. So which overtime trades at about 15x trailing earnings? To compare Bank of America's PE to a peers, we can calculate the PE for JP Morgan Chase and company, JPM, as of the end of 2020 as well. We got the stock price $127.07 diluted earnings per share, $8.88. Therefore, the PE is going to be 14.31x. So when you compare Bank of America PE of 16 to JP Morgan's PE of roughly 14x, Bank of America stock does not appear as overvalued as it did when compared with the average PE of 15 for the S&P 500. So Bank of America's high PE ratio might mean investors expect higher earnings growth in the future compared to JP Morgan and the overall market. So Bank of America is outside of course here, so they've got a higher price compared to what the earnings would be. So you would think, okay, why would that be the case? Can I explain that case or is the market basically overvaluing Bank of America? Or is there some underlying condition that can basically explain why that would be the case? However, no single ratio can tell you all you need to know about a stock. So clearly this is one of the biggest ratios that we're going to be using when we do comparisons, but there's no one number that can do it because we're using statistics to predict the future. And therefore we're trying to use a bunch of different tools to get a picture of what the future could be. And we have to do that by looking at multiple angles, for example. So before investing, it is wise to use a variety of financial ratios to determine whether a stock is fairly valued and whether a company's financial health justifies its stock valuation. Investor expectations in general, a high PE suggests that investors are expecting higher earnings growth in the future compared to companies with a lower PE. A low PE can indicate either that a company may currently be undervalued or that a company is doing exceptionally well relative to its past trends. So you could look, again, you could look either way at a high or low PE. You could say, the key is to say, OK, if something is outside the range, why is it outside the range? Why is it higher? Is it justified to be higher? Or if it's lower, you might say, well, that could be that this particular stock is undervalued, or it could be some other reason that the stock is weaker for some reason, some other reason. So you want to get the trends, get the calculation and then try to explain or try to think about why the ratio is what it is. And you might be looking at the overall market trends and so on saying, well, if people are anticipating an upturn or downturn in the market, where are they putting their money? Possibly they're over putting their money in safe places or something like that. And you can get into different trends in terms of psychology of the market psychology and why money might be going one place or another place, for example. So when a company has no earnings or is posting losses in both cases, the PE will be expressed as NA, though it is possible to calculate a negative PE. This is not the common convention. So the price to earnings ratio can also be seen as a means of standardizing the value of $1 of earnings throughout the stock market. So in theory, by taking the median of PE ratios over a period of several years, one could formulate something of a standardized PE ratio, which could then be seen as a benchmark and used to indicate whether or not a stock is worth buying. PE versus earnings yield, the inverse of the PE ratio is the earnings yield, which can be thought of as the E over the P. So now we've got the E divided by P earnings divided by the price. So the earnings yield is thus defined as EPS earnings per share divided by the stock price expressed as a percent. So if stock A is trading $10 and its earnings per share for the past year was 50 cents, TTM, it has a PE of 20, i.e. 10 divided by 50 cents, and an earnings yield of 5, that's the 50 cents divided by the 10. If the stock B is trading at $20 and its EPS earnings per share was $2, it has a PE of 10, i.e. 20 divided by 2, and an earnings yield of 10%, which is the 2 divided by the 20. The earnings yield as an investment valuation metric is not as widely used as the PE ratio. Earnings yield can be useful when concerned about the rate of return on an investment. For equity investors, however, earnings periodic investment income may be secondary to growing their investment values over time. In other words, when we look at the earnings yield for a year, that could be often a tool that we're looking at when we're comparing different yields, how much we're earning, but if we're only looking at one year out, the earnings for one year out, that's oftentimes shorter than our investment horizon because we're trying to think about what the investment is going to be longer. We might be more long focused than one year. This is why investors may refer to value-based investment metrics such as the PE ratio more often than earnings yield when making stock investments. The earnings yield is also useful in producing a metric when a company has a zero or negative earnings because such a case is common among high-tech, high-growth or startup companies, earnings per share will be negative producing an undefined PE ratio denoted in A. If a company has negative earnings, however, it will produce a negative earnings yield which can be interpreted and used for comparison. If there's negative earnings, then we're going to have an issue with the earnings per share, but we might still be able to calculate the earnings yield. So the PE versus the PEG ratio, the PE ratio, even one calculated using a forward earnings estimate, doesn't always tell you whether the PE is appropriate for the company's forecasted growth rate. So to address the limitation, investors turn to another ratio called the PEG ratio. A variation on the forward PE ratio is the price earnings to growth ratio or PEG. The PEG ratio measures the relationship between the price earnings ratio and earnings growth to provide investors with a more complete story when the PE can on its own. So in other words, the PEG ratio allows investors to calculate whether a stock's price is overvalued or undervalued by analyzing both today's earnings and the expected growth rate for the company in the future. So we're trying to take into account that future information again, making a decision on the margin at this point of time. The PEG ratio is calculated as a company's trailing price to earnings PE ratio divided by the growth rate of its earnings for a specified time period. The PEG ratios is used to determine a stock's value based on trailing earnings while also taking the company's future earnings growth into account and is considered to provide a more complete picture than the PE ratio can. For example, a low PE ratio may suggest that a company is undervalued and therefore should be bought, but factoring in the company's growth rate to get its PEG ratio can tell a different story. The PEG ratio can be termed trailing if using historic growth rates or forward if using projected growth rates. Although earnings growth rates can vary among different sectors, a stock with a PEG of less than one is typically considered undervalued because of its price is considered low compared to the company's expected earnings growth. A PEG greater than one might be considered overvalued because it might indicate the stock price is too high compared to the company's expected earnings growth. Absolute versus relative PE price earnings analysts may also make a distinction between absolute PE and relative PE ratios in their analysis. Absolute PE. The numerator of this ratio is usually the current stock price and the denominator may be the trailing earnings per share, the estimated earnings per share for the next 12 months, forward PE, or a mix of the trailing earnings per share of the last two quarters and the forward PE for the next two quarters. When distinguishing absolute PE from relative PE, it is important to remember that the absolute PE represents the PE of the current time period. For example, if the price of the stock today is 100, the TTM earnings are $2 per share, the PE is 50, which is 100 divided by the two. Relative PE. The relative PE compares the current absolute PE to a benchmark or a range of past PE's over a relevant time period such as the past 10 years. The relative PE shows what portion of a percentage of the past PE's the current PE has reached. The relative PE usually compares the current PE value to the highest value of the range, but investors might also compare the current PE to the bottom side of the range measuring how close the current PE is to the historic low. The relative PE will have a value below 100% if the current PE is lower than the past value, whether the past high or low. If the relative PE measures is 100% or more, this tells investors that the current PE has reached or surpassed the past value. Limitations on using the PE ratio, like any other fundamental design to inform investors as to whether or not a stock is worth buying, the price to earnings ratio comes with a few limitations that are important to take into account because investors may often be led to believe that there is one single metric that will complete insight into investment decisions so no one metric can do it all. Companies that aren't profitable and consequently have no earnings or negative earnings per share pose a challenge when it comes to calculating their PE. Operations vary as to how to deal with this. Some say there is a negative PE, others assign a PE of zero, while most just say the PE doesn't exist in a in other words, or is not interpretable until a company becomes profitable or purposes of comparison so obviously if there's negative profits, that's a problem for the PE ratio. A primary limitation of using PE ratios emerges when comparing the PE ratio of different companies, valuations and growth rates of companies may often vary widely between sectors due to both the different ways companies earn money and the different timelines during which companies earn that money. So when we're trying to make projections into the future, that could be difficult when we're looking at different companies, different sectors and so on. As such, one should only use PE as a comparative tool when considering companies in the same sector because this kind of comparison is the only kind that will yield productive insight. Comparing the PE ratios of a telecommunications company and an energy company for example may lead one to believe that one is clearly the superior investment but this is not a reliable assumption. Other PE considerations, an individual company's PE ratio is much more meaningful when taken alongside the PE ratio of other companies within the same sector. For example, an energy company may have a high PE ratio but this may reflect a trend within the sector rather than one merely within the individual company. An individual company's high PE ratio for example would be less cause for concern when the entire sector has high ratios. So if you see a high ratio of course you want to see it in alignment or conjunction with the other companies in that area. Moreover, because a company's debt can affect both the prices of shares and the company's earnings, leverage can skew PE ratios as well. For example, suppose there are two similar companies that differ primarily in the amount of debt they assume. The one with more debt will likely have a lower PE value than the one with less debt. However, if business is good the one with more debt stands to see higher earnings because of the risk it has taken. So leverage can have interesting impacts, right? If you're highly leveraged you're taking on more risk but you might have more access to the upside but then of course if things go down there's more risk involved. So you want to take into consideration leverage which you might talk more about in the future. Another important limitation of price earnings ratio is one that lies within the formula for calculating PE itself. Accurate and unbiased presentations of PE ratios rely on accurate inputs of the market value of shares and of accurate earnings per share estimates. The market determines the prices of shares through a continuous auction. The printed prices are available from a wide variety of reliable sources. However, the source of earnings information is ultimately the company itself. The single source of data is more easily manipulated so analysts and investors place trust in the company's offers to provide accurate information. So we have to trust the financials. If that trust is perceived to be broken the stock will be considered riskier and therefore less valuable. The fact that they're on an exchange and they're audited hopefully gives us more confidence that the information they're providing us is accurate. To reduce the risk of inaccurate information, PE ratio is but one measurement that analysts scrutinize. If the company were to intentionally manipulate the numbers to look better and thus deceive investors they would have to work strenuously to be certain that all metrics were manipulated in a coherent manner which is difficult to do. That's why the PE ratio continues to be one of the most centrally referenced points of data when analyzing a company but by no means it's only one. What is a good price earnings ratio? The question of what is a good or bad price earnings ratio will necessarily depend on the industry in which the company is operating. Some industries will have higher average price to earnings ratios while others will have lower. For example, in January 2021 publicly traded broadcasting companies had an average trailing PE ratio of only about 12 compared to more than 60 for software companies. If you want to get a general idea of whether a particular PE ratio is high or low you can compare it to the average PE of the competitors within the industry. Is it better to have a higher or lower PE ratio? Many investors will say that it is better to buy shares in companies with a lower PE ratio because this means you are paying less for every dollar of earnings that you receive. That would be the general idea that you would think, right? In that sense a lower PE is like a lower price tag making it attractive to investors looking for a bargain. In practice however it is important to understand the reason behind the company's PE. So what you really want to do is get the differences and try to say why and explain the why's of the ratios and that's really what should be leading you to your investment decisions. More than just a rule of thumb kind of thing that's based on one thing, right? So for example, I mean it's too simplified in other words just to say well it's more value because the PE ratio. For instance, if a company has a low PE because its business model is fundamentally in decline then the apparent bargain might be an illusion. So what does a PE ratio of 15 mean? Simply put a PE ratio of 15 would mean that the current market value of the company is equal to 15 times its annual earnings. Put literally if you were to hypothetically buy 100% of the company share and it would take 15 years for you to earn back your initial investment through the company's ongoing profits assuming the company never grew in the future. Why is the PE ratio important? The PE ratio helps investors determine whether the stock of a company is overvalued or undervalued compared to its earnings. The ratio is a measurement of what the market is willing to pay for the current operations as well as the prospective growth of the company. If a company is trading at a high PE the market thinks highly of its growth potential and is willing to potentially overspend today based on future earnings.