It's one of the most basic tools used to evaluate companies, yet one of the most misunderstood. Tennis star Anna Kournikova tries to explain it in a television commercial, but that's certainly no help. (And besides, ranked 38th in the world, she needs to concentrate on tennis.) It's caused more of a stir than The Anna Nicole Show. It's our friend the P/E ratio, and hopefully this column can help you use it the right way, especially when evaluating potential Drip investments.
The price-to-earnings ratio itself is simple, and has been explained well elsewhere on our site. To calculate the P/E ratio, just take a company's current price and divide it by its full-year earnings-per-share (EPS) figure.
Let's use PepsiCo (NYSE: PEP), one of our Drip holdings, as an example. Just type "PEP" into the ticker box in our Quotes & Data section, and click on the "Snapshot" button. As I write this column, the page shows Pepsi's latest price as $43.81. Scanning down, we see under the "Per Share Data" section that its trailing 12-month (TTM) earnings are $1.56 per share. So, we'll just divide 43.81 by 1.56, and we come up with a P/E ratio of about 28 for Pepsi.
Of course, we don't even have to figure this out on our own, because the P/E is listed on the same page under "Valuation Ratios." So far, so good.
... Yet confusing
Things can get confusing, however. Many times you'll see different P/E ratios given by different data providers for the same stock. That's because they're using a different earnings-per-share number as the divisor. For instance, our Snapshot page used the trailing 12-month number for EPS. Sometimes you'll see future estimated earnings used, called a "forward P/E." Some, like Value Line (Nasdaq: VALU), use a sort of hybrid, combining past earnings with future estimates.
But wait, there's more. As you know, sometimes companies report "pro forma" earnings along with the required GAAP (generally accepted accounting principles) earnings, which usually means they exclude certain charges to make their profit number larger. For example, let's say a company has had to restructure and lay off employees (not at all uncommon these days). There are almost always significant costs associated with such a move, but since they're not recurring expenses, they're normally excluded in the pro forma number.
Of course, some companies take excessive liberties with their pro forma accounting by excluding items they shouldn't. As a result, sometimes you'll see P/E ratios using the GAAP number, other times P/E ratios using the pro forma number. Unless you know a particular data provider's policy, the only way to know for sure what you're getting is to calculate the ratio yourself.
(I hesitate to add to the confusion by pointing out that EPS is simply an accounting number, and that free cash flow is a much better indicator of a company's financial health. I might get to that in a future column, but for today, we'll stick with EPS.)
What's a Fool to do?
The best way I know of to think about a company's P/E ratio is to act like you're buying the entire business for yourself. (And, when it comes down to it, you are buying the business when you buy shares.) Let me illustrate.
Several years ago, a friend and I considered buying a small, privately owned sporting goods store. The owner would not give us a selling price; instead, he told us to make him an offer. At that point, we had to sit down and figure out what the store was worth to us. And in the end, it all boiled down to profit. If the store cleared $10,000 a year, for example, what were we willing to pay for it? If the owner would accept $30,000, we'd be getting it for a P/E of just 3 (30,000 / 10,000 = 3). At $60,000, we'd be getting it for six times earnings.
It was then that the investing concept of buying the business was seared into my brain forever (right next to Stan Musial's lifetime batting average of .331). When putting my hard-earned money on the line, I wanted to make sure the business would return enough -- quickly enough -- to make it worth my while.
We wound up passing on the store, because we couldn't get a good idea of how much profit we'd actually make. Perhaps we would've been willing to wait six years to get our money back (P/E = 6), if we'd been sure of our projections. But the business was too hard to evaluate, partially because the owner's books were not transparent. We couldn't figure them out. Buying the store for even three times earnings (P/E = 3) seemed too risky.
As you can see, we used "forward P/E" when evaluating the business, because that's the only P/E that really matters. Sure, trailing earnings are useful to establish a baseline, but what really counts is what a company will earn in the future.
Dandy for Drips
This concept is especially useful for Drip investors. When considering stocks for our portfolio, we certainly try to find stable companies that won't throw too many surprises our way. After all, we buy with the intention of dri-i-i-pping money into the stock over a long period of time. We need to know that a company will be there many years down the road. While businesses with wild or uncertain futures can make for lucrative investments (see: Rule Breakers), it's not what we're about here in the Drip Port.
That's why it's critical for Drip investors to think in terms of buying the business. You need to have a good grasp of the future-earnings potential and determine a fair price to pay for that potential -- and that's nothing more than determining a forward P/E.
The harder it is to estimate future earnings (and thus the forward P/E), the more you should think about passing over the company as a Drip investment. Sticking with this rule forces you into the good habit of really learning and understanding the business before putting your hard-earned money into it.