The PE ratio unravelled

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Most investors have heard the term PE Ratio (PER), but how many of us really know what it means and, more importantly, what its drawbacks are?

It's the most common way of valuing a stock. You calculate it by dividing the price of the shares by earnings per share. Earnings per share are the net profits attributable to ordinary shareholders, divided by the number of shares issued.

Explanation

That's the easy bit. It's the variations in this number - particularly in the 'earnings' part of the fraction - that make it complicated.

Sometimes, for example, earnings calculations are based on 'fully diluted' issued shares outstanding. This takes in any extra shares that may be issued in the future as a result, for example, of the exercise of executive share options.

Earnings per share calculations also normally use 'weighted average' shares in issue. This is the average number of shares in issue during the period when the profit was being earned, giving due weight to new shares issued during the period, in accordance with the time they were issued. New shares issued at the beginning of the year carry more weight than those issued at the end.

Historic earnings

There is also the question of whether we use historic earnings - those based on profits that have been audited and announced - or forecasts of future earnings. Most professionals will use forecast earnings as the starting point for a valuation even though these may not be accurate or constant.

The real point is that forecasting is an inexact science, and analysts change forecasts at the drop of a hat. They also make forecasts for two or three years out that may be based on assumptions that are tenuous at best. The closer we get to a company's financial year end, however, the better the forecasts of that year's profits are likely to be, although the analysts could still get it wrong.

Key ratio

Whatever the rights and wrongs, however, the PER is a key ratio for analysts and investors alike. One way of looking at it is that it represents the number of years of profits at the current rate before the price of the shares is recouped in profits earned. This idea is rather notional since these profits will not be returned in full to shareholders. Flip the price-earnings ratio over (earnings divided by price) and you get what is called the 'earnings yield'. A PER of 20 times is equivalent, for example to an earnings yield of 5%.

There are those who base market predictions on the basis of a comparison between the earnings yield on an index and yields on a benchmark gilt edge stock. This is slightly spurious because shares and bonds have completely different characteristics. A gilt won't go bust, but a share could. A gilt has a fixed stream of income, whereas a share has a variable stream of income, and may generate no income at all.

Common currency

The PER does, however, enable companies to be compared irrespective of their size, the concept reducing each one to a common currency. This is important because it will, for example, enable the stockmarket rating of an individual company to be compared with its competitors and with the market. Stockmarket index compilers calculate the PER of the index as a whole and of sector groups, so that investors can see how the company's valuation compares with the market as a whole.

It actually isn't quite as simple as this, because companies may have different year-ends and different accounting policies. The PER at its simplest will not adjust for this, although most analysts do try when making forecasts to strip out as far as possible the impact of differences in accounting.

The other point to bear in mind is that the PER also often reflects the perceived growth prospects of the company in question. The higher the predicted growth in profits, other things being equal, the higher the PER. Dull, non-growth stocks tend to have lower PERs (and often higher yields too).

But, the higher PER on growth stocks is a double-edged sword. If forecast profits turn out to be less than expected, however, the whole basis for the high PER collapses and a sharp downward adjustment takes place. Not only are the profits and therefore the earnings per share less than expected, but also growth is less and the justification for the high PER evaporates. A share price is usually hit hard by this double whammy.

Peter says

The PER is widely used, and investors need to know what it means. The basic flaw in it is that it is based on earnings per share, which can be massaged and smoothed. In itself, the PER also says nothing about a company's growth prospects. Cash flow multiples are really a surer guide to company performance. Use PERs, by all means, but be aware that they are one-dimensional.