Foreword from ShareInvestor

This article “Digging Deeper Into The PE Ratio” by Lin Cai HaoXiang was first published in The Business Times on 26 Aug 2013 and is reproduced in this blog in its entirety.

*The PE ratio is one of the most popular, yet most misunderstood, ways to value a company, writes Cai HaoXiang*

Some time ago, a friend told me: “I heard markets tend to trade at a price-to-earnings (PE) ratio of 15 in the long term.”

To him, 15 was the magic number to use when deciding when to buy or sell companies. If the number is 10 or 11, perhaps it is undervalued and time to buy. If it is at 20, perhaps, it is time to sell.

This has enough of a ring of truth to be somewhat plausible. The US stock market, for example, has traded at a long-term average that is close to 15 times its earnings.

Buy when a number is low, sell when a number is high. If only life were so simple.

Here’s why it’s not.

As you will see below, just because a company is trading at a PE of 5 does not mean it is cheap and undervalued. And just because a company is trading at 15 or 20 times its earnings does not mean that it is an expensive buy.

Without understanding how the PE ratio is calculated, an investor who relies on it to make decisions is no better than one who flips a coin every day to decide whether to buy or sell.

**What The PE Ratio Is**

First, some theory.

To calculate the PE ratio, you just need two inputs: price per share, and earnings per share in a year. Divide price by earnings, and you get the aptly named price-to-earnings ratio.

Let’s say the PE ratio for a company is 10. An intuitive way to understand the number is that it will take 10 years for the company to earn back money for investors equal to the price they are paying for it. We thus say this company is “trading at 10 times its earnings”, or “is trading at an earnings multiple of 10.”

If the ratio is 2, it means it just takes 2 years for a company to earn the money back.

In short, the PE ratio is a way to figure out how much the company is trading for relative to how much money it is making for investors.

Obviously, investors would like to buy a company that trades for a low price but earns, or will earn, a lot of income. This is why people think a low PE ratio is good.

How do you get the two inputs?

The numerator is controversy-free. It is the last traded price of a stock. You get it by checking the website of a stock exchange, asking your broker, or using any stock trading programme or website.

The denominator, earnings per share in a year, is tricky. You need to understand how to get that.

Different ways to calculate earnings per share will result in different PE ratios for the same company.

Using earnings in the past 12 months will get you a historical PE ratio. Using an estimate of next year’s earnings will get you a projected PE ratio, or a PE ratio estimate. Others tinker around with how earnings are calculated. They take out one-off earnings events, or average the last five to 10 years of earnings. You will get other ratios using these methods.

For now, remember two formulas. The first is that PE ratio = price / earnings.

Switching earnings to the left hand side, you get a second formula of price = earnings * PE ratio. This means the target price for the company can be thought of as its earnings, multiplied by the number of times it is thought to trade at.

**Historical PE**

The most common way to calculate the PE ratio is to use price divided by a company’s reported earnings per share over the last 12 months.

This is known as the trailing twelve-month (TTM) PE ratio, or the historical PE ratio.

The convention is to use earnings going back one year. Note that we do not use last year’s earnings, but reported earnings for the past 12 months. In late August, where we are in now, companies would have reported earnings for the first half of 2013. Its reported earnings for the past 12 months thus includes earnings for the first six months of 2013, and for the last six months of 2012. You don’t want your data to be outdated, which would be the case if you just used 2012 earnings.

Thus we take the previous four quarterly earnings reports of the company, find the earnings per share numbers, and add them up.

**Why Low Historical PEs Are Deceptive**

But if some time passes and we get the company’s newest quarterly earnings report, we add that in and drop the oldest quarterly earnings number we previously used.

Thus, the historical PE ratio is not static. It can change dramatically depending on how its inputs change. Most notably, an earnings number drop will cause the denominator to shrink and the resulting ratio to soar. An earnings increase will cause the ratio to drop.

The changes in the historical PE ratio can be very dramatic, and this is why investors should not rely wholly on it to make decisions.

Let’s say you are interested in buying a company trading at $2 per share and 20 cents historical earnings, or a PE ratio of 10.

Is the company cheap?

Say you are tempted and buy a large stake in this particular company.

But you did not do your homework. The company’s last four quarters of earnings per share actually look like this: 8 + 3 + 4 + 5, adding to 20 cents. In other words, it earned 8 cents in the furthest-away quarter, followed by an earnings plunge to 3 cents, before slowly recovering to 4 cents and 5 cents in the last two quarters – adding up to 20 cents for the past year. Perhaps, it earned 8 cents in an extraordinarily good quarter, or there was a one-off property sale that distorted the number.

Suddenly, a bad quarter hits. Demand for the company’s products fall sharply along with a hike in raw material costs. The company reports a disastrous fall in quarterly earnings from 5 cents to 2 cents a share.

Now, its historical earnings per share are 3 + 4 + 5 + 2 cents = 14 cents. You get this after you discard the earnings for the earliest quarter (8 cents) and add the earnings for the latest quarter (2 cents).

Suddenly, the company’s historical earnings are down to 14 cents, from 20 cents previously. On a price of $2, it is now trading at a PE ratio of 14.3, or $2 divided by 14 cents.

Overnight, the PE ratio has jumped from 10, or looking somewhat cheap, to 14.3, or not so cheap any more.

It gets worse. Let’s say that in the next three quarters, the company reports earnings of just 1 cent a share each.

Within the space of 12 months, the company’s latest 12-month historical earnings are now 2 + 1 + 1 + 1 = 5 cents. Using its previous share price of $2 a share, you are now looking at a PE ratio of 40. Gulp!

**Plummeting Share Price**

If investors believe this bad year to be a temporary phenomenon, they will not take flight. But if they think a permanent shift in a company’s business dynamics has occurred, a massive share price plunge will be on its way the moment the company reports its first fall in earnings to 2 cents a share.

How much will shares fall by? Remember that price = earnings * PE ratio.

If investors believe earnings of 5 cents per share a year is the new state of affairs, they will not value the company at 40 times its earnings under the changed circumstances. They have other better companies to invest in.

New investors, meanwhile, cannot see themselves holding the company for 40 years of 5-cent yearly earnings to “make back” their investment of $2 a share.

If they value the company at 10 times historical earnings, they will only value the company at 5 cents * 10 = 50 cents. This is a far cry from $2.

They may not even value this company at 10 times earnings. Maybe they now value it at 8 times earnings. In short, they are only willing to pay 8 x 5 cents for the company – or 40 cents a share.

A price plunge from $2 to $0.40 mean an 80 per cent drop.

Big earnings disappointments are a major cause of share price volatility.

**The Rebound**

Maybe a couple of years later, our hypothetical company is still trading at 40 cents a share. Its historical earnings have plunged further to just 2 cents a year (0.5 + 0.5 + 0.5 + 0.5 = 2 cents).

The company is labelled a penny stock. Analysts have discontinued their coverage. The media stops reporting on its business activities. The public has forgotten it, except for a few investors in the forums talking about the latest rumours.

You suddenly chance across it. You look at its PE ratio: 40 cents / 2 = 20.

Hmm. But you remember that buying stocks below PE ratios of 10 are good, and that it is not advisable to buy stocks with PE ratios of 20 and above.

Is the stock expensive?

Again, the seemingly high historical PE ratio is playing a trick on you.

Suddenly, a breakthrough occurs. Perhaps the company developed an exciting product that allows it to gain clout and market share. This coincides with a population boom and cheaper raw materials.

The company has a blowout quarter, earning 3.5 cents a share. Its twelve-month earnings are now 0.5 + 0.5 + 0.5 + 3.5 = 5 cents a share, surging from 2 cents as previously reported.

Suddenly, the PE ratio of the company plunges from 20 (40 cents / 2 cents) to 8 (40 cents / 5 cents). It is looking decidedly cheap.

If you shunned the stock, you will now be kicking yourself. That is because the PE ratio does not stay at 8 in an efficient market. Traders will push the price, and thus its PE ratio up, before you have a chance to react.

**Forward PE Ratio**

The historical PE ratio is thus not the best way to value stocks that may see an earnings rebound. Instead of looking back, investors prefer to look forward and project next year’s earnings.

For example, they might think the company can gain a lot of scale not just in their home country but globally. They think the coming year’s earnings will go like this: 3.5 + 5 + 7.5 + 9 = 25 cents.

If these earnings are possible, the company will be terrifically undervalued at current prices, with a forward PE ratio of just 40 cents / 25 = 1.6 times.

The company will not be worth only 40 cents, when it is likely to earn 25 cents next year and even more for the years to come.

With everybody expecting explosive growth, maybe an earnings multiple of 12 times is more accurate to value the company, instead of 8 times. Or maybe 12 times is too conservative. How about 15, or even 20 times?

The company is now worth anything from $3 a share (12 * 25 cents) to $5 (20 * 25 cents).

This is how we sometimes see analyst reports saying that the company is worth $5 a share on a “forward earnings multiple of 20x”. In other words, the analyst is saying the stock should trade at a forward PE ratio of 20.

If the market believes in the projections we just outlined, our company will soar from 40 cents a share to $5 a share, or an increase of 1,150 per cent!

But using estimated, or forward PE ratios to base one’s investment decisions is even more dangerous than using historical PE ratios. Projections are not necessarily accurate. If enough investors believe in the wrong projection, a bubble will develop. Once again, an earnings disappointment will result in a steep price plunge.

At the height of the dotcom bubble, shares of technology companies were trading at PEs above 100 or 200, with Yahoo famously trading at well over 1,000 times its historical earnings. The bubble soon burst. Today, Yahoo trades at 27 times its core historical earnings.