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Tuesday, December 11, 2012

What's a P/E ratio?

Source: Capital Pixel
The story is told of  René Descartes getting a flash of brilliance as a young teenager that led to the Cartesian co-ordinate system that brought together algebra and geometry.  Young Descartes gave a visual depiction of algebraic equations by plotting points relative to an origin.  In this, he developed a concept that belongs in a broader family of concepts that compare and classify things - something that humans love to do and that is necessary for any type of analytical work.

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:

Homework Problems:

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?

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