Introduction to Stock Valuation: The Price-Earnings Ratio

Value investing is one of the most popular forms of long-term investing, trumpeted by such famous investors as Benjamin Graham and Warren Buffett (not to mention countless others).

The premise of value investing is to find stocks that are trading at a discount to their intrinsic value, which, admittedly, is far more difficult than it sounds. Valuation ratios are intended to help investors with this task, providing a metric to gauge the valuation of a company compared to an underlying fundamental data element. In this article, we examine the price-earnings (P/E) ratio, which is the most commonly used measure of valuation.

Throughout the course of our Financial Statement Analysis series, we looked closely at financial statements and ratios to gauge the financial strength of companies. However, no matter how financially strong or fast-growing a firm is, if the stock is not a good value, investors should think twice before purchasing shares. The price-earnings ratio helps investors assess the valuation of a firm. The ratio is calculated by dividing a company’s current stock price by its current earnings per share. It represents the number of times earnings the stock is trading at. Put another way, it shows how much investors are paying for each dollar of earnings per share. The formula is presented as:

Price-earnings ratio = current stock price ÷ current earnings per share

Analyzing the Price-Earnings Ratio

Though the price-earnings ratio is very simple to calculate, analyzing the figure is a completely different story. The price-earnings ratio is driven by both changes in share price and earnings per share. Every quarter when companies report earnings, a large change in earnings per share can increase or decrease the price-earnings ratio. The more powerful driver, however, is a change in investor expectations and perception of the firm, which is represented in its share price.

There are several variations on the price-earnings ratio, each with its own strengths and weaknesses. The two most common are trailing 12-month price-earnings ratio and forward price-earnings ratio: The first is calculated by dividing the current price by the earnings per share for the trailing 12 months (TTM P/E), the second by dividing the current price by the estimated earnings per share for the coming current fiscal year (forward P/E).

A high or low absolute price-earnings ratio does not necessarily mean that the stock is pricey or a bargain. A low price-earnings ratio generally means that most investors perceive the company to be facing an uncertain future. They are only willing to pay a small amount for a given level of earnings. On the other hand, companies trading with relatively high price-earnings ratios generally signify that investors believe the company has strong future earnings growth potential. Investors are willing to pay a larger amount per dollar of earnings, believing that profits will grow fast enough to continuing pushing share prices higher. The goal of a value investor should not necessarily be to search for companies with the lowest price-earnings ratios, but rather to search for companies that are improperly valued (in contrast to growth investors, who rely heavily on growth rates and earnings momentum). A simple screen for companies with the lowest price-earnings ratios may lead to a bevy of companies with little or no growth prospects, while companies trading at price-earnings ratios above their industry medians may not necessarily be poor values. The concept can be examined by looking at a few detailed examples.

Table 1 shows the price-earnings ratio for all the stocks in the Dow Jones industrial average (DJIA), using data from AAII’s stock screening and fundamental database, Stock Investor Pro, as of August 9, 2013. Stocks are sorted by their trailing 12-month price-earnings ratios in ascending order (lowest to highest). One of the weaknesses of the price-earnings ratio is that it cannot be used if a company has negative earnings, which can be seen in the case of Hewlett-Packard Co. (HPQ). Since the Dow components are larger and more-established companies, they typically, but not always, are profitable. However, earnings for smaller or fast-growing companies can be negative for several consecutive quarters.

For stocks that do have positive earnings, price-earnings ratios vary drastically. For example, the trailing 12-month price-earnings ratios for Dow components range from a low of 9.1 for JPMorgan Chase & Co. (JPM) to a high of 91.3 for Verizon Communications Inc. (VZ), though the vast majority are below 30.

Stocks with abnormally high or low price-earnings ratios, such as Alcoa Inc. (AA) and Verizon, are worth examining closer to determine if there is a reason they are trading at extreme valuations. Alcoa’s high price-earnings ratio can be attributed to its low earnings figure of $0.10 per share for the trailing 12-month period, which was caused by the company reporting negative earnings during two of its past four quarters. The company’s earnings releases show that during the second quarter of 2013 and the third quarter of 2012, Alcoa took charges for environmental remediation, legal settlements and restructuring. Verizon Communication’s earnings were also affected by non-operational items. The company reported non-cash expenses related to pension charges, for the early retirement of debt and for other restructuring activities. These charges led to a loss of $1.48 per share in the fourth quarter of 2012, which in turn reduced total trailing 12-month earnings.

However, investors seem to be looking past the current 12-month earnings period for both companies, as their forward price-earnings ratios are much more in line with other Dow components. Alcoa’s price-earnings ratio using the current fiscal-year (2013) estimate is 26.8 and using the 2014 estimate, the price-earnings ratio is 15.6. Verizon’s price-earnings ratio using expected earnings for 2013 is 17.6 and its price-earnings ratio using expected earnings for 2014 is 15.4.

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The forward price-earnings ratio is impacted by share price and earnings forecasts, which are provided by analysts that track the firm. When actual earnings, which are released when a company announces earnings, differ from the consensus earnings estimate, the share price is often affected, moving up or down depending on whether the difference was positive or negative.

It is also important to keep in mind that many data sources adjust earnings. Adjusted earnings generally exclude income or expenses that are non-recurring, meaning they are not typical of normal income and expenses and are unlikely to occur period after period. Different data sources and even different analysts may adjust earnings differently, so it is prudent to note how earnings are being adjusted so that you can avoid making decisions based on faulty or inconsistent information.

Making Sense of the Price-Earnings Ratio

As I stated earlier, simply looking at the price-earnings ratio as an absolute figure makes it difficult to ascertain whether a stock is overvalued or undervalued. Stocks with strong growth prospects tend to trade at higher valuations than stocks with weaker growth prospects. One way to determine if a stock is fairly valued, overvalued or undervalued is to compare the current price-earnings ratio to historical norms.

Table 1 includes the seven-year average price-earnings ratio which, for most of the stocks, is simply an average of their price-earnings ratios during the past seven years. However, a handful of stocks had negative earnings for a certain period (mostly in 2008) which led to ratios for the seven-year average that were not meaningful. In these cases, we ignored the year of negative earnings and averaged the other years. Keep in mind that this provides a historical number to use for comparison purposes but downplays the impact of bad years. The figures calculated manually using less than seven years of data are shown in blue in the table.

Comparing the current price-earnings ratio for Dow components to their seven-year average allows investors to evaluate the current valuation of companies relative to their historical norms. Table 1 shows that there are only seven companies trading below their seven-year average price-earnings ratios. This does not come as a surprise, since the market has rallied so aggressively over the past few years and has continued its momentum for all of 2013 (as of the beginning of August).

One of the main weaknesses of comparing the current price-earnings ratio to its seven-year average is that both figures are based on historical numbers, while the market is forward-looking. Using only historical figures may lead you to believe that stocks are overpriced, whereas other investors may simply be looking into future periods. If you compare the forward price-earnings ratios in Table 1 to the seven-year historical average for each stock, the ratios are much more in line. In fact, looking at the price-earnings ratio calculated using earnings estimates for the current fiscal year (2013) shows that 16 out of the 30 companies are trading at a valuation, based on forward earnings, lower than their seven-year historical average. Price-earnings ratios calculated using earnings estimates for the next fiscal year (2014) reveal 21 companies that are trading below their historical average.

It should also be noted that historical price-earnings ratio averages can have their own biases. The current seven-year average takes the 2007 to 2009 financial crisis into account, when earnings for many firms were pressured. A second weakness of using historical price-earnings ratios as a comparison is that it does not take into account the normal ebbs and flows of the market. By this, I mean that stocks naturally go through periods where they are overvalued and undervalued. As you might expect, during the end of a strong bull market, valuations are higher than they are right after a long bear market. During these market peaks and troughs, it may be difficult to compare price-earnings ratios with their historical averages, as most stocks may be overvalued or undervalued comparatively. This is where the price-earnings relative can help.

Valuing Companies on a Relative Basis

The price-earnings relative compares a company’s price-earnings ratio to the market or industry price-earnings ratio. A price-earnings relative of 1.0 means that the stock is trading at the same valuation as the market or industry, whereas a price-earnings relative over 1.0 means it is trading at a higher valuation and a price-earnings relative under 1.0 means the company is trading at a lower valuation than the market or industry. A high price-earnings relative does not necessarily mean that a stock is overvalued, if the stock has historically traded at a higher price-earnings ratio than the market (the opposite is also true). A stock that generally trades with a high price-earnings relative signals that investors believe the company’s prospects are better than those of most other companies. One of the strengths of the figure is that even during bull or bear market cycles, the price-earnings relative should be comparable.

Table 2 shows price-earnings relative figures for two technology companies [Intel Corp. (INTC) and Microsoft Corp. (MSFT)], two big oil companies [Chevron Corp. (CVX) and Exxon Mobil Corp. (XOM)] and two pharmaceuticals [Pfizer Inc. (PFE) and Johnson & Johnson (JNJ)].

We calculated the current price-earnings relative by dividing the stock’s current price-earnings ratio by the current median price-earnings ratio for all the stocks in the Stock Investor Pro database. Using data as of August 9, 2013, the current median price-earnings ratio for the universe of stocks was 18.7. The price-earnings relative average in Table 2 is the average price-earnings relative for the past five years. It should be noted that in this case, we are using a five-year historical average instead of a seven-year average. Longer time frames provide more data, but shorter time frames use more recent data.

Comparing the current price-earnings relative to the five-year average price-earnings relative provides investors with a quantitative figure to judge how a stock’s current valuation relative to the market stacks up against how it has traded relative to the market in the past. For example, over the past five years Exxon Mobil has traded with an average price-earnings relative of 0.76, meaning it has traded at a price-earnings ratio that is about 76% of the overall market median price-earnings ratio. However, its current price-earnings relative of 0.49 indicates that it is only trading at a price-earnings ratio that is 49% of the overall market median price-earnings ratio. By this measure alone, and with all else equal, Exxon Mobil is trading at a discount to where it has traded over the past five years.

Chevron tells the same story, although the variance is not as dramatic. In fact, out of these six stocks, only Johnson & Johnson is trading at a premium according to this metric.

The three other figures in Table 2 provide some additional valuation metrics that take into account the valuation of the current marketplace.

The adjusted price-earnings relative multiplies the median price-earnings ratio for the entire universe by the five-year average price-earnings relative for a company. This represents the price-earnings ratio that the stock would trade at if it were trading at its five-year average historical price-earnings relative. For example, over the past five years Exxon Mobil has traded at an average price-earnings relative of 0.76. The current database median price-earnings ratio is 18.7. Multiplying 0.76 by 18.7 gives us 14.2, the price-earnings ratio that Exxon should trade at if the stock were trading at the same valuation relative to the market that it traded at on average over the past five years.

The price-earnings relative valuation is calculated by multiplying the adjusted price-earnings relative by the company’s fully diluted earnings per share from continuing operations over the last 12 months. The figure represents the price at which the stock would trade if it traded at the same price-earnings relative valuation as it had over the past five years based on its current earnings.

Finally, the price-earnings relative valuation as a percent of price is calculated by dividing the current market price by the price-earnings relative valuation. A value of 100% indicates that the price-earnings relative valuation and the current stock price are equal. Figures above 100% may point to stock prices above valuation estimates, while figures below 100% may highlight undervalued companies. This figure allows you to assess the valuation of a stock compared to historical norms, based on its earnings.

Once again, note that these figures only take into account historical numbers, while the market is typically forward-looking. According to these figures, only Johnson & Johnson is trading at a premium; each of the other companies in Table 2 is trading at a discount relative to the market compared with their average price-earnings relatives.

Conclusion

The price-earnings ratio is the most commonly used stock valuation ratio. It allows investors to quickly gauge the valuation of a company based on its current reported earnings or estimated future earnings. A high or low price-earnings ratio does not necessarily mean that a stock is a good buy or a good sell. It simply represents investor perception of a company’s prospects and risks.

When using the price-earnings ratio in your investment research, AAII’s stock screens can provide useful guidelines. Several AAII screens use a form of the price-earnings ratio as the primary screening factor: The Dreman screens requires that the trailing 12-month price-earnings ratio ranks in the bottom 40% of all stocks (less than or equal to 16.0 as of August 16, 2013), the P/E Relative screen requires a price-earnings relative below 100%, and the Graham—Enterprising Investor screen requires trailing 12-month price-earnings ratios in the bottom decile of all stocks (less than or equal to 7.5 as of August 16, 2013). These stock screens do not look for low price-earnings ratios exclusively, but they combine a price-earnings ratio filter with other criteria, such as financial strength or earnings growth, to try to locate good companies trading at discounted prices.

For other articles in the Financial Statement Analysis series, go to www.aaii.com/journal/category/financial-statements.