## Friday, 13 November 2009

### ****A P/E ratio is a much better indicator of a stock's value than its market price alone.

Everything You Must Know About The P/E Ratio
And as a bonus, the PEG ration as well.
By Mark Vergenes

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Question: What is a P/E and PEG Ratio?
The usefulness of the price-to-earnings (P/E) and price-to-earnings growth (PEG) ratios depends on how they are calculated, what kind of market you're in, and how well you grasp their limitations. This overview can help you understand the mechanics underlying these common valuation measures and better finesse stock and market evaluations.

It's so simple, it often seems sublime. The term "P/E" or "price/earnings ratio" gets bandied about so freely, it's easy to assume that everyone knows what it is and how it's used. The ratio is one of the oldest and most frequently used metrics for valuing stocks. Though simple to construct, a P/E ratio is actually difficult to interpret. It can be extremely informative in some situations, yet virtually meaningless in other contexts.

P/E ratio explained
As the name implies, the ratio expresses the relationship of a company's per-share earnings to its stock price. To calculate the P/E, simply divide a stock's current market price (CMP) by its issuer's earnings per share (EPS):

P/E = CMP ÷ EPS
Typically, P/E ratios are historic in nature. These "trailing" P/Es are calculated using EPS from the preceding four quarters. A "leading" or "projected" P/E, alternatively, is derived from earnings expected over the coming four quarters. This P/E, of course, is an estimate. Hybrid P/Es can also be created using the EPS of the past two quarters and estimates for the next two quarters. The P/E ratio is also often called the "multiple" because it shows how much investors are willing to pay for each \$1 of a company's earnings. Not all companies, of course, produce profits. And it's these operations that create problems for analysts cranking out P/Es. When the divisor is negative (losses, after all, are manifested as negative EPS), some analysts report a negative P/E, while others bestow a P/E of zero on the company. Most analysts, however, just say the P/E doesn't exist.

The market P/E--at least, the market represented by the S&P 500 Index--has historically ranged between 15 and 25. A market P/E of over 18 is usually considered expensive, while a market P/E under 10 is considered inexpensive or undervalued. P/Es can also vary widely among different market segments. The P/E for the technology sector as of March 2005, for example, is around 28, while the overall multiple for financial companies is not quite 16.

Interpreting a P/E ratio
On the surface, a stock's P/E indicates the price the public is willing to pay for a company's earnings. A P/E ratio of 25, for example, suggests that investors are ready to fork over \$25 for every \$1 of company profits. Since a stock's price not only reflects a firm's worth now but also what investors think it will be worth in the future, this simplistic interpretation of P/E ignores growth prospects. Using forward EPS projections compensates in some measure for this.

P/Es are one of the metrics used to classify stocks as "growth" or "value" plays. As a rule of thumb, most stocks trade with P/Es 50 percent higher than their forecasted annual earnings growth. For example, a P/E of 30 would be considered reasonable for a company expected to grow earnings around 20 percent annually. That company's stock might be classified as a "growth" issue (ignoring all other factors) if it were priced above a 30 P/E, while a ratio under 30 might tip it into the "value" category.

A high P/E--that is, one above a company's "reasonable" earnings multiple or higher than the market or industry average--typically indicates very optimistic earnings prospects. A company brandishing a high P/E ratio eventually has to live up to these expectations, of course, or see its stock price drop as a consequence. A stock with a high P/E can still be a good buy for the long term, but further research may be needed to justify the price. Extreme ratios--multiples in the thousands, for instance--are typical of startups with little or no revenues.

What is "cheap"?
A P/E ratio is a much better indicator of a stock's value than its market price alone. All things being equal, a \$10 stock with a P/E of 50 is much more "expensive" than a \$100 stock with a P/E of 20. There are limits to this form of analysis, of course. A particular P/E can only be considered high or low by taking into account other factors, namely:

• Growth rates. How fast has the company been growing in the past, and is that rate expected to increase or at least continue into the future? A stratospheric P/E sported by a company that's growing earnings at a measly 5 percent annual clip might very well be overpriced.

• Industry. Apples, of course, should only be compared to other apples. Financial companies like banks typically have low multiples, while technology stocks' P/Es tend to be high. Using P/E to compare a tech company to a bank offers little actionable information. It's better to compare companies to others in the same industry or to the industry average.

Problems with P/E
While P/E ratios can point out overvalued or undervalued companies, P/E analysis is valid only in certain circumstances. For one thing, accounting rules change over time and vary from one country to the next, complicating cross-border analysis or historic comparisons. The inclusion of non-cash items, such as depreciation, into earnings further clouds the picture. Worse still, EPS can be presented in a variety of ways depending on how a company or an analyst chooses to do the math. EPS can be based upon either outstanding or fully diluted shares, for example. "Pro forma" EPS presentations can be especially vexing in comparisons, making it difficult to discern if apples are actually put up against apples.

Most importantly, P/E ratios are strongly influenced by inflation. P/Es, as a rule, head south during times of high inflation because of the resulting understatement of inventory and depreciation costs. The flip-side of this coin is that P/E ratios often seem lofty in periods of low inflation. When inflation moderates, central bank rate hikes become less likely, creating expansive expectations for earnings. Additionally, earnings quality rises, meaning that companies' improved financial results are more likely to be attributed to actual growth rather than the inflation of asset prices.

Keeping the foregoing in mind, traders tread the P/E waters carefully. A low P/E ratio doesn't automatically mean that a company is undervalued--it could actually spell trouble for the company in the near future. A company that has warned of lower-than-expected earnings, for example, might look undervalued if a trailing P/E is used as the basis for analysis. Conversely, a high P/E ratio might mean that a stock is overvalued, but that's hardly a guarantee that its price will fall anytime soon. A P/E ratio is only one part of the jigsaw puzzle that is security analysis.

Factoring in growth
While P/Es can be useful in comparing one company to another in the same industry, to the market in general, or to a company's own historical ratios, their utility is still limited. Some analysts complain that P/Es, even when based upon projected EPS, don't accurately measure a company's performance in relation to its growth potential. Factors affecting a company's growth rate--the value of its brand value, its human capital, and the like--aren't reflected in a P/E alone, they say.

Enter the "PEG" or "price/earnings growth ratio" which expresses the relationship between a company's price/earnings ratio and its earnings growth. PEGs, say some pundits, help investors see whether a company is reasonably priced given future expectations. PEGs, too, permit direct comparison of companies across industries.

A PEG is formulated as:

PEG = P/E ratio ÷ annual EPS growth
As with P/Es, the number used for the annual growth rate can vary; rates can be trailing or forward looking and cover a one- to five-year time span. Most analysts argue that longer periods make for better analyses, since their use is less likely to produce outcomes skewed by short-term anomalies.

Simplistically, a PEG ratio equal to one means that the market is pricing the stock to fully reflect the stock's EPS growth. A PEG greater than one indicates a stock that is either overvalued or one that the market expects to outdo analysts' future EPS growth estimates. Growth stocks typically have PEG ratios greater than one, reflecting investors' willingness to pay more for growth at any price. Keep in mind, though, that a high PEG could also stem from recently lowered earnings forecasts.

Undervalued stocks can be signaled by a PEG ratio below one. Alternatively, the market may not expect the company to achieve the earnings growth reflected in Wall Street estimates. Value stocks reside in this territory, but a low PEG could also indicate that earnings expectations have fallen ahead of analysts' new forecasts.

PEGs, unlike P/Es, can be used to compare stocks across industries. Consider two candidates for inclusion in a portfolio. The first, a technology company growing its earnings at a 40 percent annual clip and bearing a P/E ratio of 90; and the second, a financial firm with net income growth at 25 percent, but with a P/E ratio of only 15.

Does the higher growth rate of the technology company justify its price? Or is the financial firm a better value play?

Technology Company
Financial Company

P/E Ratio
90
15

EPS Growth (%)
40
25

PEG Ratio
2.25
0.60

The financial company has a PEG ratio of 0.60 (15 ÷ 25), relatively low for its growth rate. The technology company, with its PEG ratio of 2.25 (90 ÷ 40), is quite pricey. Compared to its industry PEG, this stock may, in fact, be overpriced. Even though the technology company seemingly has higher growth prospects, this alone may not be worth the money that investors are forking out to own the stock. Because the purchase price is so high, an investor might not get a very good return on the stock if it does grow.

Conclusion
P/Es and PEGs can be useful tools for the evaluation of portfolio prospects, but they shouldn't be used in isolation. Like all financial ratios, investors need additional information to get a clear perspective on a company. To accurately determine if a company's stock is overvalued or undervalued, the company's P/E and PEG ratios should be regarded in relation to its peer group and the overall market.

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Mark A. Vergenes, CSA (mavergenes@ehd-ins.com) with EHD Advisory Services.