Price to Earnings Ratio Explained: P/E Ratios

Why write about a PE Ratio?

Why? … because the PE Ratio is the most important of all investment valuation tools. It is not only popular but if properly used can be extremely effective as well. Essentially the PE Ratio calculates the “Payback Period” of an investment. This article looks at the effect of Growth on the PE and discusses the limitations of its use.

The Price/Earnings Ratio (“PE”) is used by investors to assess how many years it will take them to get the value of their investment back. Assuming that the earnings of the company are not growing and that the earnings are positive, then the PE Ratio of the stock will equate to the “payback period” on the investment.

The PE is not just for publicly quoted shares, but is also used in the purchase or sale of privately held companies, where exit multiples are calculated using the value paid and net profits, which may be at a discount to the Public PE multiples for companies in the same sector due to the lack of liquidity for the investor.

Growth Stocks and The PE Ration

A business can theoretically be valued using the present value of all future dividends. The Dividend Discount Model (“DDM”) is a conservative model that attributes a value to a company based on its discounted future dividends.

The basic valuation model is called the Gordon’s Growth Model and it is calculated as follows:

Value of Stock = D1/(r-g), where D1 = the dividend next year, r = the required rate of return for the equity investor, g = the growth rate of dividends in perpetuity.

The DDM is a simple model, which works quite well, when the dividends are growing at a “stable rate”. The difficultly is to find an appropriate and “stable rate” of growth for the future. In theory a firm cannot grow at a faster rate than the economy forever, so it can be assumed that a firm with a stable growth rate is one whose growth rate does not exceed expected inflation plus the expected real growth rate of the economy.

If both sides of the DDM equation are divided by the earnings per share (“E”), then the formula becomes: (Value of Stock)/E= (D1/E)/(r-g), or in other words: P/E = the payout ratio/(r-g)

Similar to the Gordon Growth Model, this PE formula is extreme sensitivity to the growth rate used. Furthermore, it does not effectively reflect the various stages of growth through which businesses go. For this purpose Multi-Phase DDM models were developed, which are not discussed in this article.

Past growth rates are often used to predict future growth rates, although Little’s study (1960) showed sequential earnings growth rates having little correlation. Nevertheless, evidence suggests that companies with little variation in their earnings in the past will have more predictable growth rates in the future.

Caution is necessary in using analysts’ forecasts to predict growth, as the quality of their forecasts deteriorates over time. Consensus numbers should also be not used blindly, although the secret of predicting growth rates may lie in discovering inconsistencies between analysts’ forecasts.

High and Low PE Ratios

It is often assumed that a Low PE means that the stock in question is a low growth stock, whereas a High PE stock is a high growth stock. This may not necessarily be the case.

In his book “The Intelligent Investor”, Benjamin Graham is categorically against Growth Stocks. He points out that their stock prices often grow at faster rates than profits and command high PE multiples based on inflated expectations, but that these stocks usually decline in the same way and are consequently too risky for the Defensive Investor. This PE contraction was experienced by many Growth Fund Managers during the 2000-2003 Bear Market, who were no match for their Value Driven peers

In his various strategies, Graham tried to gain from what we now recognize as persistent anomalies in the Efficient Market Hypothesis, such as the Low PE effect. Oppenheimer, who analyzed Graham’s methodology, says that “Graham viewed the PE as a ratio of price paid to value received and was an indicator of current market optimism about a security’s future earnings”. Graham believed in the market’s mispricing of individual securities. Only later did the academic world start paying attention to the outperformance of low P/E stocks after Basu’s article in the Journal of Finance in 1977.

Graham counselled that growth rates cannot be accurately predicted by analysts – confirmed later by Malkiel and Cragg’s study in 1970. Accordingly, the prices of growth stocks will eventually be revised downward, while low PE stocks will be revised upward.

Relative PE Ratios: The PEG Ratio

Looking at PEs in isolation may not tell you much. The investor should rather concentrate on P/E relative to growth, P/E relative to historic P/E ranges (“time series”), or P/E relative to the industry or country (“cross sectional”).

In his book “The Zulu Principle” (1992), Jim Slater advocates the use of a PE/Growth screening process, or PEG ratio, to identify securities which are undervalued in relation to their prospective growth rate. Slater states: “Many people believe that the term value investing only refers to buying assets at a discount. In fact, value investing is broader than that – the essential concept is to look for values with significant margin of safety relative to share prices.”

Slater points out that when a dynamic growth company is bought on a low P/E ratio, with a consequently low PEG factor, then those growth prospects are being bought by the investor at a discount. Slater is prepared to buy stocks at higher P/E ratios than Graham, but he claims to obtain his value by linking the P/E paid to the estimated growth rate and establishing a safety net with other criteria.

The advantage of Slater’s system is that the investor does not have to withdraw from the market until conditions are suitable. However, during periods of negative growth rates, as in the 1930s, Slater’s methodology would be largely inapplicable.

Slater’s main criteria for selecting his PEG stocks are:

·         Growth of EPS in four of the last five years, being at least 15% compound

·         A low PEG ratio of 0.75 or less, preferably under 0.66

A similar PEG strategy, tested by Peters (1991), showed the top decile achieving a return of 1536%, beating a 356% return on the S&P 500. However, the sample studied was only from 1982 to 1989.

Problems with PE Ratios: Cyclicals, Negative Earnings and Others

Assuming that a High PE stock is a Growth Stock may be fatal. The problem with this assumption is that the “E” component may be depressed as the earnings are at a low point in the economic cycle. So what you have in this case is a cyclical stock, which may not be a growth stock at all. This misleading High PE is known as the “Molodovsky Effect”, named after Nicholas Molodovsky, who discussed this issue in his article “A Theory of Price Earnings Ratios” in the Analysts Journal (1953).

Dealing with cyclical stocks can be a problem in screening stock universes. There are a number of remedies for this problem, such as using the average earnings of the previous 5 years or more, which cover one complete economic cycle. Alternatively one can move to other more stable measures such as Price to book, or Price to sales. More advanced screening tools will control for the cyclical variation in earnings by favoring those stocks where the EPS shows less volatility over the previous 5 years.

Another obvious problem in using the PE is where there are negative earnings, such as in start-ups or turnaround situations. In this case the investor should either ignore the stock, if he is a defensive investor, or use alternative measures, such as the P/Book or P/Sales already mentioned. If using the Price/Sales ratio, then as a guide, a company with a P/Sales ratio of over 5 must have excellent growth and margins. If the P/Sales ratio is under 1, then more modest growth and lower margins are acceptable.

You should use Forward Earnings for Technology companies as the numbers can change quickly. For technology companies you can also use the Price to Research Ratio (PRR). This should be less than 5 times, especially in recovery situations.

Finally the Earnings or EPS may need to be normalized for the investor to be able to use it as an effective valuation tool. Earnings can often be overstated by Extraordinary or Exceptional Items. Furthermore the EPS may need to be adjusted for the dilutive effects of shares yet to be issued as part of Executive Share Option Schemes.

Conclusion

In this article I have given an overview of the Price to Earnings ratio. The derivation of the formula and the critical importance of growth have been addressed. It has also been explained how this tool can be effectively used as a relative measure. Lastly the limitations in its use have also been outlined and some suggestions given to overcome these problems, which I hope will be of some use to the investor in his search for value.