How to Use the P/E Ratiohttp://www.fool.com/investing/value/2006/08/29/how-to-use-the-pe-ratio.aspx Philip Durell
August 29, 2006
The price-to-earnings ratio (P/E) is probably the most widely used -- and thus misused -- investing metric. It's easy to calculate, which explains its popularity. The two most common ways to calculate it are:
The share price is the market capitalization divided by the number of shares, so the results should be identical. Share price and the market cap are easy to find in the quote section of any financial website. The earnings are usually taken from the trailing 12 months (TTM) and can be found by checking the income statement for the past four quarters. A P/E using TTM figures is often called the current P/E.
Another variation is the forward P/E, which is calculated using analyst future earnings estimates, rather than actual historical earnings. Most financial websites give both the current and forward P/E. I find forward P/E a useful guide for cyclical companies, companies coming out of negative earnings, and those that have significant one-time charges embedded in current earnings. You may also encounter the dilutedP/E, which accounts for a company's diluted shares.
You'll often find slightly different P/E values for the same company on different financial sites. Why? Because some sites normalize earnings for one-time items, which distorts the P/E ratio. These small variations are immaterial.
In essence, the P/E tells us how much an investor is willing to pay for $1 of a company's earnings. The long-term average P/E is around 15, so on average, investors are willing to pay $15 for every dollar of earnings. Another useful way to look at this: Turn the P/E ratio around to look at the E/P ratio, which when expressed as a percentage gives us the earnings yield. For instance: 1/15 gives us an earnings yield of 6.67%.
Before you get carried away ...
Maybe, but maybe not. For starters, analyst expectations for Google's earnings growth over the next five years range between 23% and 62%; estimates for Mittal are currently hazy because the company is in the process of merging with competitor Arcelor. Mittal, or the combined Arcelor-Mittal entity, is unlikely to grow at more than 10% over the same time period. So clearly, future growth expectations significantly affect the significance of the P/E ratio.
Apples to apples
Investment returns also affect the P/E ratio. If I can buy shares in a company with a return on equity (ROE) of 30%, then with all other things being equal, I should be willing to pay more per dollar earned than for a company with an ROE of 10%. Consider Hewlett-Packard (NYSE: HPQ ) and Coca-Cola (NYSE: KO ) . Both currently have a P/E around 21, yet analysts expect Hewlett Packard to grow earnings at 13%, vs. 8% for Coca-Cola. Coke, however, has an ROE of 30.4%, vs. just 13.3% for Hewlett-Packard. In other words, in the past year Coke returned more than $0.30 for every $1 of shareholders' equity, while HP returned just over $0.13. Be careful in using ROE for companies with a high debt load, because it will be inflated. In that situation, using return on invested capital (ROIC) would make for a more accurate comparison.
Companies sometimes have true one-time events that can affect net earnings either positively or negatively. If a company sells a division for substantially more than its book value, the difference will be recorded as a positive in net earnings. This will distort the P/E and render it useless as a measure of value. In this case, we'd adjust the net earnings to arrive at a more useful P/E. A wide gap between current and forward P/E is a good sign that there may be a one-time event included in net earnings.
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