If anyone talks about the fundamentals of a stock to you, I am sure they will first talk about the P/E ratio. So, what is the P/E ratio?
Earnings per share is calculated by taking the total earnings divided by the total outstanding shares. P is always the same. However, the E number may be different.
As you are buying at price P today, you are only interested in what the company earns in the future. Hence, your objective is to find out the ‘real’ earnings for the future 12 months, and thus, use a ‘true’ P/E for Relative Valuation. If you believe that history is the best predictor of future earnings (or that analysts are biased), you will pay attention to trailing P/E. If you believe that analysts can accurately predict future earnings, you will use forward P/E.
The rationale of using P/E ratio is that each company is only as valuable as the earnings it can generate. However, how valuable these earnings are, are determined by 3 factors about the company: growth, risk and reinvestment needs.
Growth is the rate that the company’s earnings are growing. The more you expect Earnings to grow in the future, the higher a price you are willing to pay compared to current Earnings level. Risk is the required return on equity. The more you find that the company’s business is risky, the lower the price you are willing to pay compared to current Earnings level (as you think it is likely that this level of Earnings might disappear in the future). Reinvestment needs is the amount that the company needs to reinvest its earnings to sustain its growth. The less the company is required to reinvest to sustain its growth, the more money you get as dividends, and hence you are willing to pay more for the company.
The relationship is described as:
P/E↑=f (growth g↑, risk r↓, reinvestment needs b↓)
There is no need to go into detail regarding the mathematics, but just realise that the relationship, while present, is non-linear. Moreover, the relationship shifts with time. Those are some of the limitations of using P/E valuation. If enough readers are interested, we can have one post in the future regarding regression analysis of the different factors affecting P/E.
Some things to note:
Some of the income or expenses are one-off only (think: one-off fine). Hence, the current inflated earnings number is not at all predictive of future earnings, and you should not use it for P/E. You should instead use the normalised P/E number that adjusts all these extraordinary items out of the earnings. Remember, if the business intends to absorb fines every year as part of its normal course of operations, it is not an extraordinary item! If enough readers are interested, we can have one post regarding normalisation of the financial statements.
P/E does not consider capital structure and balance sheet; two companies that have the same net income and trading at the same price have the same P/E, yet one company can have a billion in cash reserves while the other is completely debt-fuelled. P/E reflects that only to the point that the market price incorporates the differences in risk between the two companies. Market may overcompensate or undercompensate or even ignore the differences in risk. If the market is wrong, using P/E to compare is wrong as well.
Some companies that have different business models have different “normal” range of P/E. A P/E of 15 may look good for a technology stock but bad for a utility stock. This is because people are willing to price Earnings in the Tech stock at a premium, as it is indicative of large potential future earnings.
Depending on your investment strategy (growth, deep value, GARP, top-down etc.), you may have certain additional demands for your company. Some people only buy companies with a revenue growth of 10% and ROE of 10%. Some people only buy companies with a net-cash position, or even a net-net stock. Hence, if you demand that your company must grow at a certain rate, even a stagnant company with P/E of 7 is “un-buyable” for you.