How to use P/E as a valuation tool

P/E is one of the more important fundamental valuation tools. P/E is a ratio of the stocks price and the stocks earnings per share. To calculate a P/E, take the price of the stock and divide it by it's earning per share.

Example: Stock Price $20, Earning Per share $2, gives a P/E 10.

Types of P/E, Individual and Collective

P/E can be calculated for an individual stock as well as for the overall market. To calculate P/E for the overall market, investors typically use DJIA and the S&P 500.

To calculate the market P/E in the DJIA, the investor must use the value of the DJIA divided by the earnings of its 30 components.

Trailing P/E

Trailing P/E, is when historical values are used, this does not give an indication of future performance, but does give the investor an idea of the stocks historical value which then can be compared to it's current P/E or projected P/E's. Trailing P/E ratio's are commonly used in newspapers.

Projected P/E

Projected P/E uses the current stock price divided by the stocks projected earnings per share. Projected earnings are generally provided in company research reports. Projected P/E should be used with care, since it is based on estimated earnings.

Relative P/E

The relative P/E ratio is a ratio between the current P/E and historical P/E's. A relative P/E has a numerical range of between 0-100%, representing the all time low (0%) to the all time high (100%) P/E.

For example: if a stock has historically traded with a P/E range of 10-20, and the current P/E is 20, than the relative P/E would be 100%. If the stock's P/E is 15, the relative P/E would be 75% (15 / 20 = 0.75 or 75%0 ). Some investors believe that trading in the high range of a stock's relative P/E is not considered safe since it could be considered overvalued.

Historical P/E's are not always accurate since they do not account for large events, like in 1992, which followed a large recession, when a large portion of companies wrote off assets and went into restructuring.

P/E and company growth

Company growth is reflected in the stock's P/E. The higher the company growth rate, the more expensive the stock, as measured by P/E. Growth stocks tend to have high P/E ratios, in the range of 25 to 50 times the annual earnings per share.

Investors tend to invest when they believe the company growth will accelerate, thereby increasing the price and the P/E. If the company is seen by the public to have a decreasing growth, the price tends to fall as well as the P/E.

With growth stocks, it is important to compare the earnings growth rate with the stocks P/E. Depending on the investors risk, one may consider a company with a growth rate of 20% and a P/E of 20 to be reasonably valued. A P/E which is as high as 25% above the growth rate may considered reasonable in industries like high-tech. Conservative approach would only consider stocks with a 20% growth rate if the P/E was less than 75% of the growth rate. (20 x 0.75 = 15, therefore the stock must have a P/E less than 15)

Analyzing P/E's and projected growth rates can help give the investor an indication of valuation. For example a P/E of 50 may be considered quite high, yet if the company's growth rate is estimated at 50%, then this stock would be at a discount in comparison to it's future earnings. On the other hand a stock with a P/E of 10 and a growth rate of 5% is considered overvalued.

If the company has a high P/E, the reasoning would be that it would have high growth expectations. If these expectations are not met, the higher the P/E, the higher the potential price fall. However stocks with low P/E's should not be so quickly considered based on the P/E alone. A low P/E may be a results of competition, low growth, earnings expectations and more.

Company's with low P/E's are generally considered more attractive because of two main reasons, 1) the stock will rise in price if the P/E rises to that of the industry, and 2) it can only go up. It is important when using a low P/E to always consider the companies potential growth in earnings.

Forecasting with P/E

P/E by itself is not always a good predictor of future price movements, however it is quite commonly used by investors to forecast future price level of stocks and the market.

Forecasted price = Current P/E * project annual earnings per share.

Example:
Current projected annual earnings per share is $2/share, the assumption will be that it will maintain it's P/E of 10, the estimated price at year end should be $20 ($2 X 10 = 20).

It is unlikely that the P/E should remain constant throughout the year since it is based on a moving price. The P/E will either rise or fall by the year end based on, if it the P/E is higher, than a higher price should have been reached, or it the P/E is lower at year end, than the price should be lower than projected.

Forecasted market price is calculated in the same way as forecasted price.

Forecasted Market Price = Current market P/E X total projected annual earnings per share of the market.

it should be understood by investors that forecasted prices are calculated from assumptions made on company growth, and that they are not immune to favorable/unfavorable news, competition, panic selling, business outlook and business cycles, etc.

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