The Secret Life of the PriceEarnings Ratio

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The Secret Life of the Price/Earnings Ratio

• Houston Investors Association
• Getting Started SIG
• 8 September 2007

Copy of presentation is at www.tayara.com/hia
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What everybody knows about the P/E ratio

• Widely used stock measure
• Definition P/E Price (in dollars /share)
  divided by Earnings (in dollars/share)
• Example ExxonMobil (XOM) costs 84.26/share and
  earned 6.80/share.
• P/E 84.26/6.80 12.4
• Often called Price Multiple or Earnings
  Multiple
• Used for valuing and comparing stocks
• Simple!!!
• Examples here and following are from ValueLine
  report of 15Jun2007

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But wait theres more

• Which P/E did you have in mind?
• There are lots of definitions, and they are
  different
• What share price to use? Which earnings to use?
• Whats a good P/E?
• How do I know if a P/E is too high, low, or just
  right?
• How do I use it?
• What if E bounces around a lot?
• What about one-time windfalls?
• What if the company is losing money?
• Whats the P/E of the whole stock market?
• Is it safe to go into the water yet?

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Two Main Flavors of P/E

• P/E (Trailing Earnings)
• Definition Current Price / Last 12 months of
  Earnings
• Also called P/E TTM (Trailing Twelve Month)
• Fairly objective based on measured actual data
• Ignores likely near-term events and performance
• Tends to be higher (current price/previous
  earnings)
• P/E (Forward Earnings)
• Definition Current Price / Forecast next 12
  months Earnings
• Also called Future P/E, Estimated P/E, Forward
  P/E, etc.
• Subjective depends on analyst estimates
• Incorporates likely near-term events and
  performance
• Tends to be lower (current price/future earnings)

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Other Varieties of P/E

• P/E Current Earnings (ValueLine)
• Blend of TTM Forward P/E
• Definition Current P / (Last 6 months E Next 6
  months E)
• Average Annual P/E
• Average Price over 1 year / Earnings
• More representative than using Price at a point
  in time
• Median P/E
• Relative P/E
• Smoothed (normalized) P/E
• Aside Earnings Yield
• Earnings Yield is simply the reciprocal of P/E
• Earnings per share / Price per share (expressed
  as percent)
• E.G. XOM Earnings Yield 1 / P/E 6.81/84.26
  8.0

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What is a good P/E?

• Why is a stock worth anything?
• WRONG Because I can sell it to a greater fool
  for more than I paid
• RIGHT A share of stock is a claim on the
  earnings of the underlying business
• How much will you pay for the current (and
  future) level of earnings?
• Currently people are paying 12.50 for each 1.00
  of XOM earnings (P/E12.5). Is that cheap?
  Expensive?
• Reference Point P/E of a bank Certificate of
  Deposit
• CD costs 1000 and pays 50/year interest (5
  yield)
• P/E 1000/50 20
• So 20 is a fair P/E for 100 safe stream of
  earnings that doesnt grow

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So what is a good P/E for a Stock?

• On the one hand On the other hand
• If we expect earnings to grow, should be willing
  to pay more now to enjoy larger earnings in the
  future ? P/E gt 20
• But what if earnings fail to grow, or company
  goes bankrupt? Considering risk, we should pay
  less than for a sure thing ? P/E lt 20
• In general, it depends
• Fast growing companies trade at higher P/E, but
  often risky.
• Slow growing companies trade at lower P/E, but
  often safer.
• The higher the P/E, the more speculative the
  investment.
• Exceptions Intel (P/E22), GM (P/E7). Which is
  safer?
• Super Big Caveat Stockholders may never enjoy
  earnings squandered or expropriated by management
• Disclaimer For illustration only. Dont use
  P/E20 as an investment guide!!!

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Using the P/E

• P/E normalizes price and earnings, allowing
  direct comparison
• Both Earnings E and Price P vary widely over time
  for a single stock and between different stocks
• How would you like to price apples? Dollars per
  basket? Or dollars per pound?
• Compare a stock to
• its history
• its future
• its close peers
• its industry
• the market
• Compare the entire market to reality

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Compare a stock to its history

• Median P/E
• Definition Mid value of a series of annual P/E
  values
• Represents typical value for a stocks P/E
• Useful for comparing historical and current
  values
• E.G.
• XOM 10-year median P/E 18.1, but current TTM
  P/E 11.9
• Should we buy?

Source Morningstar
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Compare a stock to its future

• What will XOM trade for in 5 years?
• (If I knew, I wouldnt tell you)
• Hard to forecast Price all by itself
• Easier if we separate into 2 parts Earnings, and
  P/E ratio
• Forecast from ValueLine
• XOM earnings will grow slower in the future,
  6/year vs. 14/year over last 10 years
• XOM P/E will be 12.5, lower than historic 18.1
• Therefore, in 5 years, XOM will price will be
• P Present Earnings x Earnings Growth x future
  P/E
• 5.40 x (1.06)5 x 12.5 90
• Corresponds to 3 annualized total return
• Is XOM expensive or cheap?
• Note ValueLine normalizes or smoothes current
  E by averaging over last 3 years before
  forecasting future E

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Using the P/E cont.

• Compare a stock to its peers
• XOM P/E 84.26/6.80 12.4
• Shell Oil P/E 76.70/8.30 9.2
• Is Shell cheaper than XOM?
• Compare a stock to its industry
• Average current P/E of oil cos. is 10.0
  (ValueLine)
• Compare a stock to the market
• Relative P/E Divide a stocks P/E by P/E of
  overall market (as represented by SP500 or other
  index)
• Allows for comparison with market at present and
  over time
• E.G. XOM P/E (12.5) / Market P/E (19.5) 0.64

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Compare the market to reality
Source Robert Shiller
You are here
35
50 yr average
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What Drives P/E?

• Earnings growth
• Business cycle
• Inflation
• Interest rates
• Investor exuberance/depression
• a.k.a. Greed Fear

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P/E of Cyclical Stocks

• For cyclicals P/E highest when earnings are
  lowest (opposite of what you expect)
• Corresponds to low point in business cycle
• E declines, but P stays roughly the same

Dow Chemicals
Recession
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Pitfalls of P/E

• Earnings variability
• Need to smooth, correct for business cycle
• Choosing wrong comparisons
• Like to like peers, industry, size, maturity,
  etc.
• Not understanding why P/E is large or small
• Watch out for GM! (and Google?)
• Not all Earnings are created equal
• Quality of earnings
• What does management do with retained earnings?
• Good versus bad growth
• Maybe EVERYTHING is overvalued?
• P/E of overall stock market

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Summary

• Defined P/E ratio(s)
• Seen examples of P/E
• Used P/E to compare stocks
• Glimpsed P/E of overall stock market
• Pitfalls

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References for this presentation

• Will the Real P/E Please Stand Up?
• AAII Journal Aug 2007 pp. 15
• http//www.aaii.com/includes/DisplayArticle.cfm?Ar
  ticle_Id3211 (membership required)
• Standard Poors SP500 data spreadsheet
• http//www2.standardandpoors.com/spf/xls/index/SP5
  00EPSEST.XLS
• Four Pillars of Investing (William Bernstein)
• Best book I can recommend for new investors
• Irrational Exuberance (Robert Shiller)
• Outstanding book on overall market valuation
• http//www.econ.yale.edu/shiller/data.htm
• Investment Analysis and Portfolio Management
• by Frank K. Reilly, Keith C. Brown
• For the serious student