Now we come to the most popular valuation measure- the Price to earnings ratio or the PE ratio, which can take you pretty far as long as you are aware of its limitations. The nice thing about P/E is that accounting earnings are a much better proxy for cash flow than sales, and they are more up-to-date than book value. Moreover earnings per share results (and estimates) are easily available from just about any financial data source imaginable, so it’s an easy ratio to calculate.
The easiest way to use a PE ratio is to compare it to a benchmark, such as another company in the same industry, the entire market, the industry average, or the same company at a different point in time. Each of these approaches has some value, as long as you know the limitations. A company that’s trading at a lower P/E than its industry peers could be a good value, but remember that even firms in the same industry can have very different capital structures, risk levels and growth rates, all of which effect the Price to earnings ratio. All else equal, it makes sense to pay a higher P/E for a firm that’s growing faster, has less debt, and has lower capital re-investment needs.
You can also compare a stocks P/E to the average P/E of the entire market. However the same limitations of industry comparisons apply to this process as well. The stock you are investigating might be growing faster (or slower) than the average stock, or it might be riskier (or less risky). In general, comparing a company’s P/E with industry peers or with the market has some value, but these aren’t approaches that you should rely on to make a final buy or sell decision.
However comparing a stock’s current P/E with its historical Price to earnings ratios can be useful, especially for stable firms that haven’t undergone major shifts in their business. If you see a solid company that’s growing at roughly the same rate with roughly the same business prospects as in the past, but it’s trading at a lower P/E than its long-term average, you should start getting interested. It’s entirely possible that the company’s risk level or business outlook has changed, in which case a lower P/E is warranted, but it’s also possible that the market is simply pricing the shares at an irrationally low level.
This method works generally with more stable, established firms than with young companies with more uncertain business prospects. Firms that are growing rapidly are changing a great deal from year to year, which means their current P/Es are less comparable to their historical P/Es.
P/E drawbacks
Relative P/Es have one huge drawback. A PE ratio of 12, for example, is neither good nor bad in a vacuum. Using PE ratios only on a relative basis means that your analysis can be skewed by the benchmark you are using. (peer, industry, market).
So, let’s try to look at the PE ratio on an absolute level. What factors would cause a firm to deserve a higher PE ratio? Because risk, growth, and capital needs are all fundamental determinants of a stock’s PE ratio, higher growth firms should have higher PE ratios, higher risk firms should have lower P/E, and firms with higher capital needs should have lower P/E. We can see why this is true, intuitively.
Firms that have to shovel in large amounts of capital to generate their earnings run the risk of needing to tap additional funding, either through debt (which increases the risk level of the company) or through additional equity offerings (which may dilute the value of current shareholders’ stake). Either way, its rational to pay less for firms with high reinvestment needs because each dollar of earnings requires more of shareholders’ capital to produce it.
Meanwhile, a firm that’s expected to grow quickly will likely have a larger stream of future cash flows than one that’s growing slowly, so all else equal, it’s rational to pay more for the shares (thus the higher Price to earnings ratio). On the flip side, a firm that’s riskier –maybe it has high debt, maybe it’s highly cyclical, or maybe it’s still developing its first product –has a good chance of having lower future cash flows than we originally expected, so it’s rational to pay less for the stock.
When you are using the Price to earnings ratio, remember that firms with an abundance of free cash flow are likely to have low reinvestment needs, which means that a reasonable PE ratio will be somewhat higher than for a run-of-the mill company. The same goes for firms with higher growth rates, as long as that growth isn’t being generated using too much risk.
Some other aspects that can distort PE ratios
A few other things can distort a PE ratio. Keep these questions in the back of your mind when looking at P/E, and you’ll be less likely to misuse them.
Has the firm sold a Business or an Asset recently?
If a firm has recently sold off a business or perhaps a stake in another firm, it’s going to have artificially inflated earnings, and thus a lower P/E. Because you don’t want to value the firm base don one-time gains such as this, you need to strip out the proceeds from the sale before calculating the P/E.
Has the firm taken a big charge recently?
If a firm is restructuring or closing down plants, earnings could be artificially depressed, which would push the P/E up. For valuation purposes, its useful to add back the charge to get a sense of the firm’s normalized P/E.
Is the firm cyclical?
Firms that go through boom and bust cycles –commodity companies, auto manufacturers are good examples –require a bit more care. Although you will typically think of a firm with a very low trailing P/E as cheap, this is precisely the wrong time to buy a cyclical firm because it means earnings have been very high in the recent past, which in turn means they are likely to fall off soon.
Does the firm Capitalise or Expense its Cash flow generating assets?
A firm that makes money by inventing new products –drug firms are the classic example- has to expense all of its spending on research and development every year. Arguably, it’s that spending on R&D that’s really creating value for shareholders. Therefore, the firm that expenses assets will have lower earnings –and thus a higher P/E- in any given year than a firm that capitalizes assets. On the other hand, a firm that makes money by building factories and making products gets to spread the expense over many years by depreciating them bit by bit.