FOOL SCHOOL
Valuation: The P/E Ratio

January 7, 2002

After a traditional Christmas holiday break welcome back to the new term at the Fool's School. In January this series of articles will run through the basics of how to value shares. We kick off with one of the most popular measures, the P/E or Price Earnings Ratio.

First of all though, a few words of warning. Valuing shares or indeed any other asset is not a precise science. It's more of an art. There are no definitive answers to whether a share is cheap, expensive or about right. Most people use a number of valuation measures in order to get a feel for whether a share offers good value or not. It's also important to be consistent about how you use valuation measures. For each different method there a number of ways you calculate the answer. If you want to compare valuations at different times or for different companies you have to make sure you're comparing apples with apples.

The P/E Ratio

The price to earnings ratio (P/E) is the most widely quoted number when investors attempt to put a value on a share. You will often see something like "Dodgy.com trades at a forward P/E of 10, making it look fully valued," or "Epic! has a trailing P/E of 30, which makes it look cheap in comparison with other companies in the sector." But why is Dodgy.com considered "fully valued" and Epic! thought to be "cheap"? At what is the difference between a forward and a trailing P/E?

The P/E is a one-dimensional number and needs to be viewed in the context of growth rates, the industry, competition and many of the other valuation tools we shall look at.

The P/E is calculated as:

Share Price
-----------------------------
Earnings Per Share (EPS)


EPS is calculated as:

Net Profit (after tax but before dividends)
---------------------------------------------
Number of Shares Outstanding


Let's take an example. Epic! is a relatively new company but it is already profitable. Last year it made the conveniently round number of £1m in profits after tax. Even more conveniently it has 10m shares in issue on the stock market. So its EPS can be calculated as:

£1,000,000
---------------- = 0.10 or 10p
10,000,000


Epic!'s current share price is 300p, so the P/E is:

300p
------- = 30
10p

This is a trailing or historical P/E because it is calculated on past profits. You can also calculate P/Es based on earnings estimates for the current year. The stock market is forward looking so many people prefer to use forecast P/Es rather than historical ones. However, whilst the historical numbers cannot change, forecasts may alter as the year progresses. Many people use these two PEs in conjunction.

But what does that mean? Is Epic! incredibly cheap or wildly overvalued? It is impossible to say just by looking at the P/E on its own. It largely depends on what people expect the profits of Epic! to do in the future. Perhaps the £1m in profit mostly due to a one-off contract that won't be repeated. Or perhaps it was just a small part of an ongoing deal expected to last for many years. The point is that an investor needs a lot more information than the P/E number alone to attempt to put a value onto the company.

Say a machine that prints one £10 note per year is offered for sale. Inflation is zero. Its earnings are £10 per annum, and it has one share in issue. How much would you be prepared to pay for the machine? Clearly, if you could buy that machine for £10 (P/E = 1), you would have a bargain. On the other hand, paying £300 (P/E = 30) would be a bit rich. In this case, the ideal P/E is equal to the number of years it takes for a buyer to recoup the initial investment. For a real company with real products operating in an inflationary environment, looking at the P/E in such a simple way is just not possible.

It is often said that in a fairly valued situation the P/E should roughly equal a company's future EPS growth rate. In the current economic environment, where interest rates are low and the stock market is at historically high levels, it is much more difficult to find great companies that pass that test. Also, perhaps investors are looking a little longer term than they did in the past and are willing to pay a higher premium for future growth. For example, a company trading at P/E of 30 but forecast with some certainty to grow at 20% per annum for the next 10 years may still offer value.

Other valuation articles:
The PEG ratio
Price to Sales
Dividend Yield
Return on Equity
Return on Equity and Goodwill
Uses of Return on Equity
Balance Sheet Basics
Discounted Cash Flow