## Thursday, June 30, 2011

### Price/Earnings Ratios

Price/Earnings Ratio is, basically, the stock price divided by the Earnings per Share (EPS). So, if you have \$1.25 of EPS and a current price of \$10.00, then you have a P/E of 8. (Price divided by P/E Ratio gives Earnings. For example \$10.00 divided by 8 gives earnings of \$1.25. EPS times P/E gives you the price.
For example, \$1.25 EPS times 8 gives you \$10.00.)

Usually when people talk about a Forward (or Leading) P/E Ratio, they are using the current stock price and EPS estimates for the current financial year. The Trailing P/E Ratio is using the current stock price and EPS for the last financial year. There are variations on this with Forward P/E Ratios using current stock price and next 12 months of EPS and Trailing P/E Ratios using current stock price and last 12 months of EPS.

On my spreadsheets, I calculate Price/Earnings Ratios for Closing, High, Low and Median stock price for each financial year. My median stock price is the median of the high and low stock prices for each financial year. When I give a current P/E Ratio, I am using current stock price and EPS estimates for the current financial year. When I give trailing P/E ratios, I am using the current stock price and EPS for the last financial year.

In order to see if the current P/E ratio is a reasonable one, I compare it to P/E ratios I calculated over the last 5 financial years. The stock price is probably reasonable if the current P/E ratio is around the median P/E ratio of the past 5 years. It is also valid to compare a company’s current P/E to current P/E ratios of similar companies.

I also like to compare the 5 year median Price/Earnings ratios for high and low stock prices to the current P/E ratio to get an idea if the current price is relatively high or relatively low. Realistically, while it is nice to pay a low price for a stock, getting one at a reasonable price is probably more attainable.

When comparing P/E ratios, you need to compare trailing P/E ratios to trailing P/E ratios, and current P/E ratios to current P/E ratios. Remember current is also called forward or leading P/E. In a rising (bull) market, the trailing P/E ratios tend to be higher than the current P/E ratios and the opposite in a falling (bear) market.

A financial year for a company is taken from the date of their annual financial statements. Most companies use the calendar year. That is a year beginning 1 January and ending 31 December. Some companies have non-calendar financial years. Our banks are examples of this. The TD Bank’s (TSX-TD) financial year begins 1 November and ends 31 October every year. Others, like Canadian Tire (TSX-CTC.A) have financial years ending on the closes Saturday to 31 December. For example, the financial year for 2010 started 3 January 2010 and ended 1 January 2011.

As I understand Price/Earnings Ratios, 10 and below is consider low, 15 – 20 is considered normal and 25 or 30 is considered high. This is just a rule of thumb. However, companies like utility companies tend to have low P/E Ratios and tech companies tend to have high ones. Also, mature companies tend to have lower P/E ratios than growth companies.

When companies change from a growth company to a mature company, their P/E ratios will tend to come down. Also, for some companies, investors are willing to pay a higher price (or a premium) for its stock. This will result in higher P/E Ratios that similar companies have. This can occur for various reasons.

There are, of course, problems with this ratio. The earnings part of the ratio is rather a fake number. This is because, for the P/E ratio to mean anything, all companies, across all industries have to calculate earnings in the same way. Earnings also seem to be a value that can be more easily manipulated that say cash flow. So, perhaps it is not a good idea to put too much weight on the earnings value.

I think that the Price/Earnings Ratio is one valuable tool for determining if a company’s stock price is reasonable or not. However, I do not think that it should be the only thing you should use.

Other possible ratios to use are Price/Sales Ratios and Price/Book Value. You can also use Graham Price, Dividend Yield and Return on Equity to determine if the stock price is reasonable or not. Under the new account rules for Canada (IFRS) it has been suggested we should also use Return on Comprehensive Income.

The site Investopedia has a tutorial on Price/Earning Ratio. The site Wikipedia has an informative article on the Price/Earnings Ratio.

Site such as Globe & Mail, in their stock summary used a P/E that is based on the last 12 months EPS. If you go to financials and add up EPS for last 4 financial periods, you will get the EPS used in their P/E Ratio. The Forward P/E ratio is supposed to be based on EPS estimates. However, I cannot match earnings used on this site (or others sites using same estimates) for the Forward P/E. Google Financial also gives P/E ratios for various stocks. See Google Finance.

Usually sites state what they are using as the EPS. Some use Diluted EPS and others Undiluted EPS. I use the Diluted EPS. Sites can also vary on the P/E Ratios depending on how up to date they are in what they use for EPS. You need to be aware of how a site gets their EPS. They usually always use the current stock price.

Also Yahoo gives current P/E ratios by industry. However, please be aware that this is geared towards the US market, not the Canadian market.

This blog is meant for educational purposes only, and is not to provide investment advice. Before making any investment decision, you should always do your own research or consult an investment professional. See my website for stocks followed and investment notes. Follow me on twitter.