Price-to-Earnings Ratio

Graham and Dodd's investment bible, Security Analysis, stressed the importance of the price-to-earnings (P/E) ratio when it was first published in 1934. The book called P/E "a concept that the working analyst will have to deal with extensively."

At first glance, the ratio seems relatively simple: The price of a stock, divided by its earnings per common share.

But P/E is more complicated than that. How it's calculated can vary, and the weight it's given can also change. And not long ago, some market gurus even questioned its merit in determining a company's value in the New Economy.

But the dot-com bust has since brought P/E back to the forefront, and experts say the calculation still serves as a crucial tool for smart investing.

"This ratio has been around for decades. It's always been important," says Ray Martin, president of CitiStreet Advisors LLP in Quincy, Mass. "But with the fallout of the dot-com stocks that had no earnings, they're placing as much emphasis as they ever had on P/E ratios."

Calculating P/E ratios is straightforward. If a company's stock sells for $10 with $5 earnings per common share, the P/E ratio is 2. There's a hitch, though: Not everyone uses the same definition of earnings.

"It's profits, but it's not so easy to define profits," says Robert J. Shiller, an economics professor at Yale University in New Haven, Conn., and the author of Irrational Exuberance (Princeton University Press, 2000). "Accountants have been debating that for 100 years."

Analysts sometimes apply earnings from the previous year or next year's estimated earnings to calculate a P/E ratio. They might use the last quarter's earnings multiplied by four, or apply earnings that are calculated before interest, taxes, depreciation or amortization.

The most traditional approach is to use trailing 12-month earnings, as reported by companies.

"We just found that trailing four-quarter earnings is more reliable," says Kari Bayer, a quantitative strategist at Merrill Lynch & Co. in New York.

Still, not everyone favors using past earnings, says Kei Kianpoor, CEO of New York-based Investars.com, which provides peer-group analysis tools for the investment community. "Looking at historical earnings and taking that P/E, you would have a safer bet," he says.

But what if that company doesn't expect any earnings in the upcoming year? "I think estimated future earnings are much better, but you need excellent projections," he adds.

Obviously, past earnings can't be applied to start-ups, either.

"The price-to-earnings ratio wasn't even calculable [for new companies], because they didn't have any earnings," says Richard DeKaser, chief economist at National City Corp. in Cleveland.

Nevertheless, knowing a company's P/E ratio doesn't necessarily mean much. A more important gauge of a company's financial health is "how does it compare to stocks in its peer group?" Martin says.

Take the stock of two financial services firms, for example. One might sell for about $20, the other for about $50. The $20 stock on face value might be cheaper, but let's assume that it has a significantly higher P/E. The better value would be the $50 stock, Martin explains.

"It's like going to the grocery store and unit pricing," he says. It's similar to paying $4 for 48 ounces of orange juice vs. $3 for 24 ounces.

Despite the market's volatility, it does follow some P/E trends. For example, more mature industries, such as the automotive sector, tend to have lower P/E ratios because they're not expected to grow as quickly as newer industries, such as the software sector. "The higher the number, the greater the optimism that investors are attaching to its future income stream," DeKaser says. There's also more risk attached to the stock.

Another evolving trend is the steep rise in the stock market's overall P/E ratio. Although the historical average is approximately 13 or 14, P/E ratios for the Standard & Poor's 500 reached the low 30s in late 1999 and early 2000 - a startlingly high figure that DeKaser calls "unprecedented."

And don't expect the market's ratio to tumble with the economy. That's because the market's P/E historically goes up during an economic downturn, experts say. "It's not because the price of stocks generally goes up. On the contrary, it's because earnings get depressed and fall," explains DeKaser.

S&P 500 P/E Ratios

The P/E ratio is a measure used to gauge a company’s value. It reflects the value the marketplace puts on a company’s earnings and its prospects for generating future earnings. A P/E ratio is calculated by dividing the market price of a common share of stock by its earnings per common share. This chart reflects the P/E ratios for the Standard & Poor’s 500 over the past 34 years.*

29BQS_se.gif
* Based on four-quarter forward operating earnings. (Data prior to 1990 based on stock valuation operating earnings.)

Red horizontal lines represent periods of rising earnings.

Pratt is a freelance writer in Waltham, Mass. Contact her at markmary@mindspring.com.

Related:

Copyright © 2001 IDG Communications, Inc.

7 inconvenient truths about the hybrid work trend
Shop Tech Products at Amazon