Sushi Money

Many investors, if they have been investing in individual stocks for any length of time are well aware of the P/E ratio for the companies they invest in.  Today we’ll examine some considerations and uses for the P/E ratio.   But what is P/E really?  Quite simply, the P/E ratio is a measure of the Price or Market Value per share of stock divided by the companies Earnings per share of stock.  For example, if stock ZZ is trading at $20 per share and the company earnings over the past 12 months were $1.25, then the P/E ratio would be 16.  This measure is typically shown as a trailing P/E ratio… taken from earnings over the past year.  The P/E ratio is also known as the “multiple” or “price or earnings multiple.”

•  Why is a P/E ratio useful?  Because it gives potential investors one way to measure how much to pay for or value a corporation’s stock as compared to its earnings.  This is useful in many ways, not simply looking at one company but also comparing that company to its peers in similar industries, or as a historical evaluation of that company’s earnings growth over time. It may also be appropriate when used within similar market sectors to understand how those companies are valued by the market… businesses grow in different ways and are subject to cyclic economic forces as well.  Some industry profits fluctuate in much greater ways than others. 
• Low versus high:  So a low P/E ratio means that a given stock is inexpensive as compared to it’s earnings right?  Well… maybe.   It may be too simple to say that a low P/E stock is a good investment, because there may be many reasons the P/E ratio happens to be low for a given stock.  Equally, simply because a P/E ratio is high doesn’t necessarily make it a poor investment, although it probably carries more risk and is a more volatile choice compared to the market as a whole.  High P/E ratios usually indicate that investors expect the company to grow profits at a faster rate over time.  Low P/E ratios may simply reflect consistent earnings, but slow growth over time. There are market sectors where P/E ratios tend to be higher, such as technology companies that may grow faster, and market sectors where P/E ratios tend to be lower such as the banks and utilities that grow earnings at a slower pace.  That’s why it’s important to look at the history for a given company or market sector, as well as the current issues facing the company and future forecasts.  And that’s also why there are countless analysts out there making a living by looking closely at various businesses and sectors… to make their best estimates on future prospects.  
• How can I use the P/E ratio?  Most commonly we see the P/E ratio shown as a trailing P/E ratio… the price over earnings per share is taken from earnings over the last four quarters or 12 months.  But a forward P/E is also useful as a projected or estimated P/E based on earnings forecasts over the next four quarters.   We generally accept trailing P/E at face value, but analysts often disagree over the future P/E based on estimates.   That perhaps is the heart of the analyst’s job… to listen to the company’s forecasts and examine the business sector as well as the overall economy.  Sometimes outsiders see things that those working inside the company do not… national or global trends and data that may affect a company two years from now.   Sometimes there are forces that no one could forecast… a national crisis, or a crisis half a world away that affects the business of a local company.  Or perhaps a new company invents a better widget… changing the trends and dynamics that an older company was counting on to earn its business profits.  The wonderful world of investing!
• What else do we need to consider?    There are many different methods to analyze business data of course.  We are talking about P/E, but many of the other ratios are also based on the data a company reports each quarter.  We expect that a given company is reporting its earnings properly, with sound accounting… being forthright and not trying to hide anything.  That’s not always been the case, and even today we read of various companies restating earnings or some scandal where a company is trying to recover credibility with investors over how they manage and report company data.  So in that sense P/E is not a pure statistical ratio when used for analysis… because part of the formula depends upon something that is very human… the statement of earnings.  Those earnings are obviously figured out and reported by people, and some of which may be subject to manipulation.  All things being equal, we expect that solid companies, like GE or AT&T for example, will conduct their accounting and quarterly reports in a sound manner.  In many ways that is why a corporation’s credibility in reporting and forecasting is so important… investors and analysts expect that a company generally knows what it’s talking about and they make decisions based on those estimates.  When a company “misses” its earnings or has a particularly bad quarter, investors want to know why… and obviously they may lose money.  That’s also why good companies will “warn” or give notice to investors about particular events that may affect their earnings in a given or future quarter.  It may be bad news, but it shows the business is serious about letting investors know what is going on with their earnings.
• So what do you do with P/E?  For me it’s one of the criteria I use before making an investment… but my criteria is a little more strict these days.  I generally don’t invest in companies unless their P/E is lower than 22.  Ideally I would like to choose companies with a P/E of less than 18.  This isn’t as simple as it sounds however.  In the last 12 months I bought shares of eBay (EBAY)… they currently have a P/E around 40!  But their forward P/E is closer to 20 or 22.  They are still growing earnings pretty fast.   I also bought shares of Conoco-Phillips… (COP)big oil, big profits right?  At least lately, and their earnings have usually been consistent.   Yet sometimes the oil companies have problems with politics, refinery issues, etc.  Their P/E ratios are usually pretty low… when I bought COP, the P/E was 10, with a forward P/E of 7!    Interestingly, you can also evalute the average P/E for the mutual funds you hold.  One of the funds I have is Vanguard Wellesley Income (VWINX).  On Yahoo Finance you can look at the data and see the average P/E for the fund- for VWINX it’s been between 14 and 16 over the past couple years.  It also shows a comparison with the fund’s peers. 

In recent years investors have favored lower P/E stocks… during the height of the dotcom craze P/E multiples were inflated many times over. Many investors reasoned that the future of these companies, whether or not they made money, was extremely bright and they would either be fast growing, or be bought out quickly making equally rapid gains in the price of the stock.  I invested in many of those companies… I lost money and made money, but learned a valuable lesson… it’s important to try and find a fair valuation for a company I will invest in if I’m going to invest for the long term.  In many ways I take a value approach… find a good company I want to invest in and then wait… wait for the time that the stock is out of favor or down at a lower earnings multiple when the market is down.  Usually I invest in those companies that pay dividends as well and hold the stock for several years or more.  Oh one more thing… do you invest in a company that doesn’t even have a P/E ratio, hence isn’t making any real earnings per share?  Well… not me.  It may be a small company with huge future growth capability, but those are speculative investments that I don’t have the time or patience to watch.  Lots of folks like to trade those stocks. Lots of risk may equal lots of return… or loss!

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