P/E Ratios: What They Are and How They’re Used

Several years ago I was asked by one of my more astute, knowledgeable clients if I could help him better understand the Price to Earnings or P/E ratio.  Before I tell you how I answered him and his response, let me give you the abbreviated version of a basic P/E ratio.

First, the P: this is the current price of shares for a company and it can be found with a quick online search or newspaper (they still print those don’t they?).  Now, the E: this is the earnings per share. Earnings are key to supporting the stock price and the P/E ratio reflects how high the stock price is relative to the earnings of the business. So, if a stock’s price (P) is $100 and the earnings per share (E) are $5.00 the P/E ratio would be quoted as 20x ($100 divided by $5.00).  Said another way, for every $1 of earnings of the company, you are willing to pay $20.  Investors compare this P/E ratio with the ratio for similar businesses or the average stock market to evaluate whether the stock of a business is selling at an attractive level. There are many complexities beyond this basic explanation though, which leads me back to my client’s request.

Given this individual’s business and investment experience I was initially a bit surprised at the question, but I happily launched into an explanation similar to the paragraph above: that it was probably the most common gauge used for judging equity market valuations and was a calculation by which one divided the current price of a stock or an index by its corresponding earnings. Conceptually, the higher the number, the more expensive the stock and vice versa. He chuckled, thanked me for what I now realize must have been a long winded explanation, and then proceeded to explain why he’d really asked.

He understood the concept of a P/E ratio and what it was used for, but couldn’t understand what constituted a high, low, or what he’d heard someone call a “fair” P/E.  It turns out he’d been watching one of the now far too numerous business and market-focused television channels and had heard several investment professionals mention the market P/E, but they’d all referenced drastically different numbers.  He understood why there may be slight variations, but not the significant differences he’d noted from the show’s guests.  I finally now understood the real question!

The Price to Earnings ratio or multiple on the surface is indeed a straightforward calculation.  In the real world, unfortunately things that appear simple can be anything but.  The P is actually still easy, but the E is a whole different story!  The investment industry in its never ending (and expectedly fruitless) quest to create the perfect forecasting model has devised numerous ways to arrive at an “E”.  We’ll stick to the three most common – Forward “E”, Trailing “E”, and Normalized “E”.  Each version of “E” leading to a different P/E ratio and the understandable confusion of that client.

Before we jump any further into any of the three, perhaps it makes sense to pause for a quick explanation of each of the three buckets.  The summary version is that each of the “E” groupings covers a different time period and one (forward) is an estimate and not actual.

• Forward P/E – the “E” in a forward P/E multiple is typically the estimated earnings per share for the next 4 quarters or year
• Trailing P/E – the “E” in the trailing P/E multiple is typically the sum of the prior 4 quarters of actual reported earnings
• Normalized P/E – this is easily the most confusing with the greatest variance or tweaks in terms of how professionals calculate it.  The most recognized version was developed by Yale University Professor Robert Shiller (who won a Nobel prize for his work) in which he compared price to the average inflation-adjusted earnings from the prior 10 years.  It’s also referred to as the Shiller Ratio or CAPE ratio (Cyclically Adjusted PE Ratio).

In our initial example let’s assume the Forward “E” of $5.00 is what we were referencing, but the trailing “E” may have been $4.25, and the normalized just $3.50 resulting in three very different P/E’s of 20x, 23.5x, and 28.6x.  As my client now realized, a P/E ratio without an explanation of the “E” component is nearly useless as the range of outcomes varies too significantly.  In the following two charts you can see just how much not just the “E” varies, but also the resulting P/E Ratio. 

The variation in the “E” and the resulting P/E ratios is pretty obvious, in particular around the tech bubble and financial crisis, but there are also some other patterns worth noting.

With regard to the “E” component, forward earnings tend to be consistently the highest.  That is not unusual and is the result of two things.  First, while companies are not always going to be successful the expectations of companies and analysts is that earnings will grow over time, so it would make sense that they would be higher than either of the backward looking, historical metrics (trailing or normalized).  Secondly, analysts are typically overly optimistic in their forecasts which tends to inflate that number further.  The result is that in the P/E graph that forward ratio tends to be the lowest across time (the higher the “E” the lower the P/E).

Trailing tends to be the most volatile of the “E”’s.  That is not unexpected and is one of the drawbacks of using the trailing ratio.  Trailing figures are not averaged like the normalized figures and have far fewer observations (4 vs. 40 for the Shiller Ratio).  Quarter by quarter actual results can fluctuate quite a bit during normal environments, but even more significantly during periods of economic and market stresses.  Since these stress periods typically happen quickly and without warning forward estimates rarely (I never say never, but…. never) predict or incorporate them either.

The normalized figures tend to be much smoother and lower.  The smoother pattern owes to the longer observation period and averaging that the other two methods do not utilize.  The lower overall level owes to the theory that over time companies earnings will increase, so if we are incorporating older and older data it will naturally drag the “E” down.

If you are like that client from years ago, you now hopefully have a bit better understanding, but at the same time may be more confused.  Understanding one number was difficult enough without adding in two other versions and figuring out how and when to use each.  Does it matter?  Which one should we care about?  Which one do you, my advisor, rely upon?

Anyone who knows me or my writing style likely knows there is a long drawn out answer to each of those questions, but for the sake of brevity that’ll have to be the topic of a follow up discussion!  The reality is that none of them are perfect, but they are all relevant.  My belief is really that any metric used by investors as the basis for investment decisions has relevancy – regardless of whether I agree with it or use it in my work or analysis.

I will leave you with one answer though and that is the one that I use and rely on more than the others – the normalized ratio.  Investment professionals who expect to add value for their clients must be prepared to act when the opportunity presents itself.  That is typically at market extremes.  The normalized ratio intentionally looks through short-term fluctuations in price and earnings and puts the emphasis squarely on the long term when it is most needed and the opportunities are the greatest.  It still takes courage or guts to buy when the market is in panic mode (or sell when the market is euphoric), but having the right time horizon and metrics that match is imperative.

At Smith and Howard Wealth Management, we believe that our clients are best served over the long term through a combination of our understanding and close monitoring of valuations and overall market conditions, our approach to diversified investments across asset classes and financial planning that is consistently monitored and updated as needed. It is our goal to help you achieve your financial goals. Please call me at 404-874-6244 or email me with any questions.

Read Part Two of this article on Price/Earning Ratios here.

Unless stated otherwise, any estimates or projections (including performance and risk) given in this presentation are intended to be forward-looking statements. Such estimates are subject to actual known and unknown risks, uncertainties, and other factors that could cause actual results to differ materially from those projected. The securities described within this presentation do not represent all of the securities purchased, sold or recommended for client accounts. The reader should not assume that an investment in such securities was or will be profitable. Past performance does not indicate future results.