The P/E is not what you thought it was…

August 26th, 2008

The Earning Per-Share (EPS) by itself does not mean much. Most investors employ the Price to Earnings (P/E) ratio to examine a company’s earnings relative to the price of its shares. The P/E ratio, often called “multiple”, divides the stock price by the last four quarters’ EPS (this is the same as dividing the market capitalization of the company by its total earnings). For instance, if ABC Corp. is currently trading at $15 a share and its last four quarters’ EPS is $1, it would have a P/E of 15. It could be a surprise for many of you, but this well-known ratio has substantial drawbacks that Wall Street analysts, who frequently use it, won’t tell you.

The P/E is used by many analysts and investors to trace bargain stocks. The underline assumption is that companies that run similar businesses (i.e. are from the same industry) should have a similar P/E. Therefore, low P/E stocks are often considered a bargain. Is it really true? Not always.

While some low P/E stocks could be cheap, many of them are not such attractive investments. For example, consider a company with a low P/E that has a large debt. In this case, the market cap of the company does not truly reflect its real value. The company’s real Enterprise Value (EV) would be the sum of its market cap and its debt (minus the company’s cash), making the numerator larger, thus the P/E will be larger than what it was initially calculated to be.

Simply stated, it means that the real price of the stock is not as cheap as it seems to be. On the other hand, if a company has a higher P/E ratio, it doesn’t necessarily mean it is not cheap. If this company is loaded with cash, then again its market cap wouldn’t reflect its true value; in this case the EV of the company would be its market cap minus its cash, thus dramatically lowering the P/E value. In order to avoid this problematic feature of the P/E, it is wise to use a different ratio, called the Earning Yield (EY), which is calculated by dividing the earnings of the company by its EV.

Another problematic feature of the P/E is its dependence on the company’s past performance. The earnings of the past 12 months are not necessarily an accurate prediction of future earnings. A company could have a uniquely profitable year for many reasons but its future earnings could be ambiguous. Therefore, looking only at the trailing 12 months’ P/E is kind of like driving while looking out the rearview mirror- it is important, but the obstacles you need to be careful of lie ahead of you. In other words, many stocks that are traded with low P/E these days often deserve to have a low P/E because of their questionable future prospects.

One of the not so commonly used ratios, which can solve this issue, is the Price to Earning Growth (PEG) ratio (The PEG is calculated by dividing the P/E ratio by the company’s predicted annual growth rate). The PEG simply takes the annualized rate of growth out to the furthest estimate and compares this with the current stock price. Since it is future growth that makes a company valuable, the PEG ratio makes a lot of sense. But this is not the end of the story, since the PEG also has a crucial problematic feature – it depends on the assumed growth of the company, a parameter which is obviously unknown by itself.

In any case, considering a low P/E ratio as an initial screening criterion for finding bargain stocks could be useful. However, this by itself does not assure a cheap stock, and additional criteria must be considered in order to find a true bargain (e.g., stocks with low Price/Book Value).

Last 5 posts by Yinon Arieli

• How cheap are stocks now? - October 26th, 2008
• New Wall Street Terminology - October 18th, 2008
• What does Warren say? - October 15th, 2008
• Should you buy now or wait for a better time? - October 2nd, 2008
• Understanding Fundamental and Technical Analysis - September 27th, 2008

Tags: EPS, PEG, Price ot Earning

Entry Filed under: Stock Trading Investing Basics