An avid reader recently asked a two-part question: Why do investors put so much store in a stock’s P-E (price-earnings) multiple and is the ratio as reliable an indicator as many professionals suggest? The short answers are: 1) P-E ratios are extremely helpful in comparing investment choices. 2) They are reliable but only in context. I will explain.
Why This Particular Ratio
This indicator is a simple calculation that divides the stock’s current price per share by its annual earnings per share. Because it tells the investor how much earnings he gets for a given investment, it’s extremely handy when comparing one stock to another, even if they are in very different businesses.
The ratio has its roots in an old investment rule-of-thumb that dates back into the mists of time. Long before there were organized stock markets, merchants would assess the merits of a business opportunity by estimating how long it would take to earn back their original investment. If someone offered them, say, one twentieth of their business for an investment of a certain amount, they would immediately ask how much the business earned during the last year. With that information, they could calculate how many years it would take for them to earn back their initial investment, after which time the deal would be pure profit for them. The shorter the earn back period, the more attractive the deal, all else being equal. The calculation also offered an easy metric for comparisons to other deals. If another business owner offered them a share that would pay back in less time, it would (all else being equal) be more attractive. The P-E ratio gives the same information.
Another way to look at the P-E multiple is to turn it on its head. The upside down ratio, instead of telling you how many years’ earnings you must pay for a share, tells you the earnings as a rate of return on the initial investment. A P-E ratio of 20, for instance, pays you one twentieth of your investment every year or 5 percent. Expressing things as a percentage not only allows comparisons to other stocks, but it also enables the investor to compare a prospective stock investment to the yields on bonds and interest rates paid on deposits.
Kinds of Multiples
Whether presented right side up or upside down, there are more than one kind of P-E multiple. Some investors prefer to measure the price relative to the previous year’s earnings. They argue that those earnings are definite and involve no dubious estimations. Others construct the ratio using the current year’s earnings, claiming that these are more up to date and only involve estimates for that part of the year not yet done. Still other investors prefer to make the comparison with estimates for next year’s earning. This approach has the drawback of being a pure estimate, but future earnings, after all, are what you are buying.
There is an additional consideration. The number of shares in the market today may differ from the number going forward. The company might buy back shares, holding them as what are called “treasury shares” and thereby reducing the number of shares available for purchase in the open market. The company could also sell additional shares, and so increase the number available for purchase. Buyers are seldom in the know of such plans. They can, however, know about options outstanding. These enable others (often executives of the company) to buy newly created shares directly from the firm. Such potential purchases can often significantly change P-E calculations, and it is something that any P-E calculation should take into consideration. In cases where multiples appropriately account for the potential of conversions from options into shares, the calculation is said to be fully diluted.
Is the P-E Multiple Reliable?
Yes, but only up to a point. A company with rapid earnings growth will in time give shareholders claims on much more earnings than in the year they bought the stock. Such stocks can remain attractive even though they have a much higher P-E multiple than companies with slower-growing earnings. For example, an exciting technology company may look more attractive than a utility even if the stock on that technology company carries (to use financial jargon) a higher P-E multiple. Similarly, a company dominating a secure industry offers greater security about future earnings than a small player in an uncertain industry, making it more attractive even if it carries a higher price-earnings ratio. These assessments put price-earnings ratios into necessary context before the investor makes a decision. To do justice to the information provided by these ratios, the investor must also add considerations of competition, the quality of management––indeed, the whole array of issues involved in securities analysis.