Companies are most commonly valued via their earnings. Also called net income or net profit, earnings are the money left over after a company pays all of its bills. To allow for apples-to-apples comparisons, most people who look at earnings measure them according to earnings per share (EPS).
You arrive at the earnings per share by simply dividing the dollar amount of the earnings a company reports by the number of shares it currently has outstanding. Thus, if XYZ Corp. has 1 million shares outstanding, and it's earned $1 million in the past 12 months, it has a trailing EPS of $1. (It's called "trailing" because it looks at the numbers reported in the previous four completed quarters.)
$1 million in earnings / 1 million shares = $1 earnings per share (EPS)
The earnings per share figure alone means absolutely nothing, though. To look at a company's earnings relative to its price, most investors employ the price/earnings (P/E) ratio. The P/E ratio takes the stock price and divides it by the last four quarters' worth of earnings. For instance, if, in our example above, XYZ Corp. was currently trading at $15 a share, it would have a P/E of 15.
$15 share price / $1 in EPS = 15 P/E
Is the P/E the Holy Grail?
Many individual investors stop their entire analysis of a company after they figure out the trailing P/E ratio. With no regard to any other form of valuation, this un-Foolish group blindly plunges ahead, purposefully ignoring the vagaries of equity analysis. Ben Graham popularized the P/E, but he also used many other techniques beyond to isolate value, too. Today, the P/E has been oversimplified by its devoted fans, who search primarily for companies that sport a very low price relative to their trailing earnings.
Also called a "multiple," the P/E ratio is most often compared against the current rate of growth in earnings per share. Some argue that that for a fairly valued growth company, the P/E ratio should roughly equal the rate of EPS growth.
Returning to our example, if we find out that XYZ Corp. grew its earnings per share at a 13% over the past year, it would suggest that at a P/E of 15, the company is pretty fairly valued. Fools believe that P/E only makes sense for growth companies relative to the earnings growth.
If a company has lost money in the past year, or has suffered a decrease in earnings per share over the past 12 months, the P/E becomes less useful than other valuation methods we will talk about later in this series. In the end, P/E must be viewed in the context of growth; you can't consider it by itself without greatly increasing your potential for errors.
Are low P/E stocks really a bargain?
With the advent of computerized stock-screening, low-P/E stocks that have been mispriced have become increasingly rare. When Ben Graham formulated many of his principles for investing, he had to search manually through pages of stock tables to ferret out companies with extremely low P/Es. Today, simply punching a few buttons on an online database will give you a list as long as your arm.
This screening has added efficiency to the market. When you see a low-P/E stock these days, it often deserves that gloomy metric because of its questionable future prospects. Intelligent investors value companies based on future prospects, not past performance, and stocks with low P/Es often have dark clouds looming in the months ahead. True, you can still find some great low P/E stocks that the market's simply overlooked for some reason. But when you do, you'll need to confirm these companies' real value by applying some other valuation techniques.
The PEG and YPEG
Two commonly used applications of the P/E ratio are the P/E and growth ratio (PEG) and the year-ahead P/E and growth ratio (YPEG).
The PEG simply takes the annualized rate of growth out to its furthest estimate, then compares this with the trailing P/E ratio. Since future growth makes a company more valuable, it makes sense that higher growth rates should increase a company's valuation. Relying solely on a trailing P/E in this regard would be like trying to drive with your eyes fixed on the rearview mirror.
For instance, if a company is expected to grow at 10% a year over the next two years, and it has a P/E of 10, it will have a PEG of 1.
10 trailing P/E / 10% projected EPS growth rate = 1.0 PEG
The lower the PEG ratio, the more cheaply a company is valued. If the company in the above example only had a P/E of 5, but was expected to grow at 10% a year, it would have a PEG of 0.5. If the company had a P/E of 20 and expected growth of 10% a year, it would have a PEG of 2.
While the PEG is most often used for growth companies, the YPEG is best suited for valuing larger, more-established ones. The YPEG uses the same assumptions as the PEG, but it looks at different numbers. Rather than basing the P/E ratio on trailing earnings, it compares the stock price to earnings estimates for the year ahead. It then uses estimated five-year growth rates, which are readily available from several quote sources. Thus, if the forward P/E is 10, and analysts expect the company to grow at 20% over the next five years, the YPEG is equal to 0.5.
Fools should view the PEG and YPEG in the context of other measures of value, rather than considering them magic money machines.
Rather than trying to look at growth rates, many investors simply look at estimated forward earnings, then guess what fair multiple someone might pay for the stock. For example, suppose XYZ Corp. has historically traded at about 10 times earnings, and it's currently down to 7 times earnings because it missed estimates one quarter. If the missed quarter was just a short-term anomaly, it would be reasonable to expect that the stock will return to its historic 10 times multiple.
When you project fair multiples for a company based on forward earnings estimates, you start to make a heck of a lot of assumptions about what that company will do in the future. With enough research, you can reduce the risk of being wrong, but it will always still exist. Should one of your assumptions prove incorrect, the stock probably won't go where you'd expect it to. That said, most of the other investors and companies out there are using this same approach, making their own assumptions as well. In such a worst-case scenario, at least you won't be alone.
In a modification to the multiple approach, you can also determine the relationship between the company's P/E and the average P/E of the S&P 500. If XYZ Corp. has historically traded at 150% of the S&P 500, and the S&P is currently at 10, many investors believe that XYZ Corp. should eventually hit a fair P/E of 15, assuming that nothing changes. This historical relationship requires some sophisticated databases and spreadsheets to figure out, and it's more often used by professional money managers than individual investors.
For more lessons on valuation methods, follow the links at the bottom of our introductory article.