Finding a Stock's "True Value" Using The Price-Earnings Relative Screen
by Wayne A. Thorp, CFA
Since the S&P 500 fell almost 40% in 2008, there are now bargains to be had in the stock market. That is not to say, however, that all stocks are priced attractively.
The price-earnings ratio (P/E)—or earnings multiple—is one of the most popular measures of company value. It is the current stock price divided by earnings per share for the most recent 12 months.
In this article
- Price-Earnings Relative
- The P/E Relative Screen
- Screen Performance
- Overview of Passing Firms
- Conclusion
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The popularity of the price-earnings ratio stems from how it relates the market’s expectation of future company performance—embedded in the stock price component of the equation—to a company’s actual recent earnings performance.
The price-earnings ratio is primarily driven by stock prices, although earnings also respond to changing business conditions. When greater risk and uncertainty in company prospects are perceived, valuations decline as investors are only willing to pay a small amount for a given level of company earnings. The greater those expectations, the higher a multiple of current earnings investors are willing to pay for the promise of future earnings.
But price-earnings ratios are not across-the-board comparable in terms of value. How, then, do you judge whether a company’s price-earnings ratio represents good value?
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