The Price/Earnings Ratio P/E Ratio

1. The Price/Earnings RatioP/E Ratio Dr. Clive Vlieland-Boddy

2. 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 • Relatively Simple!!!

3. But wait: there’s 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? • What’s 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? • What’s the P/E of the whole stock market? • Is it safe to go into the water yet?

4. What is a good P/E for a Stock? 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/E=22), GM (P/E=7). Which is safer? Super Big Caveat • Stockholders may never enjoy earnings squandered or expropriated by management

6. Price Earnings Valuation Method • The price earning ratio (PE) is a widely watched measure of how much the market is willing to pay for $1 of earnings from a firm. • A high PE has two interpretations: • A higher than average PE may mean that the market expects earnings to rise in the future. • A high PE may indicate that the market thinks the firm’s earnings are very low risk and is therefore willing to pay a premium for them.

7. Price Earnings Valuation Method • The PE ratio can be used to estimate the value of a firm’s stock. • Firms in the same industry are expected to have similar PE ratios in the long run. • The value of a firm’s stock can be found by multiplying the average industry PE times the expected earnings per share. P/E x E = P

8. Price Earnings Model: Example • The average industry PE ratio for restaurants similar to Applebee’s is 23. What is the current price of Applebee’s if earnings per share are projected to be $1.13? • P0 = P/E x E • P0 + 23 x $1.13 = $26.

9. Price Earnings Valuation Method • Advantages: • Useful for valuing privately held firms and firms that do not pay dividends. • Disadvantages: • By using an industry average PE ratio, firm-specific factors that might contribute to a long-term PE ratio above or below the average are ignored.

10. Using the P/E • P/E normalizes price and earnings, allowing direct comparison - 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

11. 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 stock’s 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

12. Compare a stock to its future • What will XOM trade for in 5 years? • (If I knew, I wouldn’t tell you) • Hard to forecast Price all by itself • Easier if we separate into 2 parts: Earnings, and P/E ratio • Forecast from Value Line • 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

13. 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 stock’s P/E by P/E of overall market (as represented by S&P500 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

14. Compare the market to reality Source: Robert Shiller You are here 35% 50 yr average

15. What Drives P/E? • Earnings growth • Business cycle • Inflation • Interest rates • Investor exuberance/depression It is all about perceived future expectations!

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