|Source: Capital Pixel|
Here's another example: suppose one basketball player makes 79 of 112 foul shots and another made 57 of 89. Who has the better record? The comparative device here--the device that puts them on the same footing--is the percentage calculation. The first player made 70.5% of his or her shots and the second player made 64 percent. Percentages make comparisons of these types simple, and they are used almost without thinking. Take a stroll through Costco and you'll see people with calculators figuring the per ounce cost of 2 different cans of tuna.
For investment analysts, the most widely-used comparative metric is the P/E ratio. Ask whether stock ABC is a better value than stock XYZ and, invariably, the very first number you will get is the P/E ratio, where P is price and E is earnings. In fact, as you read views on the likely direction of the overall market, you will frequently see references to the market P/E relative to historical P/E.
So let's back up and think about this. Suppose I told you that stock ABC is earning $1.50 per share and stock XYZ is earning $.75 per share. Is ABC the better value? When you reflect on this a bit, you realize that you really can't say. ABC may have a price of $30 and XYZ a price of $10. The price of ABC is 3 times the price of XYZ, but its earnings are only 2 times as much.
All of this is equalized and put on a comparative basis by the P/E ratio. For our example, ABC has a P/E ratio of 20 and XYZ 13.33. We say that for ABC "you have to pay $20 per dollar of earnings," etc. Thus, from this perspective, it is easy to see that ABC is more expensive, i.e., you have to pay up for a dollar of earnings for ABC.
But this is just the first step. It may very well make sense to pay up for ABC. It depends on its expected growth. Studying P/Es is just the first step. But it is a huge first step.
As you study P/Es, you quickly come to realize there are various measures. There are P/Es based on trailing earnings (ttm stands for "trailing 12 months") and there are P/Es based on expected earnings. There are also P/Es based on normalized earnings that use adjustment techniques to get at the underlying trend.
Here, for example, is what you get on Yahoo! Finance for Johnson & Johnson:
|Source: Yahoo Finance|
CLICK IMAGE TO ENLARGE Check that the P/E ratio of 23.08 is correct by taking the price 70.45 and dividing by EPS of 3.05.
P/Es are also used to classify investment approaches. For example, value managers focus on lower-than-average P/E stocks whereas growth managers focus on stocks that have higher P/Es whose earnings are growing faster than average.
As mentioned above, P/Es are also used to assess the overall value of the market. One of most popular is the Shiller P/E 10 ratio. This measure uses 10 years of earnings adjusted for inflation. It is used by so-called tactical asset allocators and market timers to assess entry and exit points in the U.S. stock
market. Here is an update Shiller P/E ratio graph from gurufocus:
1. Find the P/E ratios of VZ, MON and MSFT. Which of these stocks do you believe is the value now? (Hint: go to Yahoo! Finance and put in ticker symbols.)
2. According to the Shiller Price/Earnings Ratio, is now a good time to invest in U.S. stocks?