MAY 2003

Lesson 303

What Do P/E's Mean?

Price

Earnings

P/Es in Context

Putting it All Together

What Do P/E's Mean?

The price-to-earnings ratio (P/E ratio) is the most widely-used measure of a company's valuation by the stock market. In Lesson 112, we discussed a fund's average P/E ratio. In this class, we'll delve a bit more deeply into what the P/E ratio means and how it can be used to evaluate stocks and fund portfolios.

The P/E ratio measures a company's stock price relative to its earnings per share. To calculate the P/E ratio, divide a company's share price by its earnings.

If ABC Company has a price of $40 a share, and earnings of $2 a share, its P/E ratio will be 20. Taken another way, this means that investors are willing to pay 20 times ABC Company's earnings to own stock in this company.

This amount might be more -- or less -- than investors have paid in the past. It might also be more -- or less -- than investors are paying to own similar companies or companies in the entire stock market.

Like many other measurements or ratios, the P/E ratio doesn't mean much in isolation. And while its useful to compare P/E ratios to historical measures for a company, sector or entire market, there are limitations on what the P/E ratio can tell you.

Price

Many investors are confused by P/E ratios because they see so many different figures quoted for the same company.

Basically, a company's P/E ratio changes frequently because its price changes constantly. Stock prices change from minute to minute when the stock exchanges are open.

P/E ratios aren't that useful if calculated from minute to minute, so generally investors calculate and use them based on a certain period of time.

Investors might use the high and low price of a stock over a year's time to calculate a high and low P/E ratio. Once that is done, those two figures can be used to find out an average P/E ratio for an entire year.

Because companies operate on differing fiscal years that may or may not align with the calendar year, it is a good idea to calculate P/E ratios using a company's fiscal year rather than the calendar year. This leads to more realistic, consistent P/E ratios.

Earnings

The earnings part of the equation changes quarterly, when companies report their earnings to the public. Earnings can also differ depending on how they are calculated and interpreted.

Companies report earnings in a variety of ways, and they are subject to interpretation by analysts. Many companies report actual earnings and pro forma earnings, which exclude certain expenses and revenues.

Once reported, analysts dissect a company's earnings and may use actual reported earnings, pro forma earnings or normalized earnings. Normalized earnings remove expenses or revenues that are unusual and aren't likely to be repeated.

As you can figure out, there are many analysts that look at companies, so there is a very wide range of how they will interpret a company's earnings and what actual numbers they will use.

The traditional P/E ratio is based on what is known as trailing earnings. Trailing earnings are the last four quarters of a company's earnings. P/E ratios can also be calculated for future earnings periods.

P/E ratios from the past can tell us how a company's P/E has performed in past years. Some companies have a range of P/Es that are characteristic of that company, while other companies have P/Es that vary widely.

Since investors pay for future growth, it can be useful to estimate what a company's P/E might be in the future. To do this, you'd need to use future earnings estimates or a combination of past and future earnings estimates, using the current price of the stock.

The fact that earnings can be calculated in so many different ways accounts for many of the different P/E ratios you will encounter for a single company.

P/Es in context

P/Es are an important measure of investor sentiment towards a company. Because investors prefer companies with strong, predictable earnings, these companies will command a higher P/E ratio than those of companies with more volatile and less predictable earnings.

They also reflect investor sentiment towards the economy and market in general. When the economy is booming, stock P/E ratios are generally higher than when the economy is in recession.

Historically, P/Es have had a relationship to interest rates and inflation. When interest rates and inflation are higher, P/Es tend to fall because investors are getting higher interest rates for investing in bonds, and are typically less attracted to stocks.

When interest rates and inflation are falling, investors are more willing to assume the risks inherent in stocks in order to gain more capital appreciation. This attitude leads to P/E expansion in the overall market.

P/E ratios are also very sensitive to a sector's favor in the market. When a sector is in favor, P/E ratios for a majority of companies in that sector tend to be higher. When a sector is out of favor, P/E ratios for companies in that sector tend to retreat.

Putting it all together

Because funds invest in many different stocks, the P/E ratio of one particular stock isn't that important when it comes to evaluating a fund.

What is important is the P/E ratio of all the stocks in the fund average together. It is also important to understand what a P/E is, and what factors can influence this important ratio.

Fund data providers generally weight the fund's average P/E ratio so that larger positions in the portfolio have more influence on the ratio than smaller positions.

For comparison purposes, fund data providers will give the average P/E ratio for a fund's peer group or to the S&P 500 or a relative measure of the fund's past P/E ratios. A fund's average P/E ratio in comparison with a market benchmark or other, similar funds, can tell you a great deal about the fund's portfolio.

For example, the P/E ratios of value funds tend to be lower than growth funds. Value fund managers seek out undervalued companies, which tend to have lower P/Es than growth companies.

Aggressive growth funds tend to have higher P/Es than pure growth funds, as managers of these types of funds are willing to pay a premium for rapid growth or even the expectation of rapid growth.

While P/E ratios don't tell the full story of a fund, they can tell you a lot about the types of companies that the manager invests in and if these companies are over or undervalued by the market.