Showing posts with label Price to future earnings. Show all posts
Showing posts with label Price to future earnings. Show all posts

Thursday 12 November 2009

Price to Future Earnings

Price to Future Earnings

The price earnings ratio cannot be estimated for firms with negative earnings per share. While there are other multiples, such as the price to sales ratio, that can still be estimated for these firms, there are analysts who prefer the familiar ground of PE ratios.

One way in which the price earnings ratio can be modified for use in these firms is to use expected earnings per share in a future year in computing the PE ratio.

For instance, assume that a firm has earnings per share currently of -$2.00 but is expected to report earnings per share in 5 years of $1.50 per share. You could divide the price today by the expected earnings per share in five years to obtain a PE ratio.

How would such a PE ratio be used? The PE ratio for all of the comparable firms would also have to be estimated using expected earnings per share in 5 years and the resulting values can be compared across firms. Assuming that all of the firms in the sample share the same risk, growth and payout characteristics after year 5, firms with low price to future earnings ratios will be considered undervalued.

An alternative approach is to estimate a target price for the negative earnings firm in five years, divide that price by earnings in that year and compare this PE ratio to the PE ratio of comparable firms today.

While this modified version of the PE ratio increases the reach of PE ratios to cover many firms that have negative earnings today, it is difficult to control for differences between the firm being valued and the comparable firms, since you are comparing firms at different points in time.

Illustration: Analyzing Amazon using Price to Future Earnings per share Amazon.com has negative earnings per share in 2000. Based upon consensus estimates, analysts expect it to lose $0.63 per share in 2001 but is expected to earn $1.50 per share in 2004. At its current price of $49 per share, this would translate into a price/future earnings per share of 32.67.

In the first approach, this multiple of earnings can be compared to the price/future earnings ratios of comparable firms. If you define comparable firms to be e-tailers, Amazon looks reasonably attractive since the average price/future earnings per share of etailers
is 65. If, on the other hand, you compared Amazon’s price to future earnings per share to the average price to future earnings per share (in 2004) of specialty retailers, the picture is bleaker. The average price to future earnings for these firms is 12, which would lead to a conclusion that Amazon is over valued. Implicit in both these comparisons is the assumption that Amazon will have similar risk, growth and cash flow characteristics as the comparable firms in five years. You could argue that Amazon will still have much higher growth potential than other specialty retailers after 2004 and that this could explain the difference in multiples. You could even use differences in expected growth after 2004 to adjust for the differences, but estimates of these growth rates are usually not made by analysts.

In the second approach, the current price to earnings ratio for specialty retailers, which is estimated to be 20.31, and the expected earnings per share of Amazon in 2004, which is estimated to be $1.50. This would yield a target price of $30.46. Discounting this price back to the present using Amazon’s cost of equity of 12.94% results in a value per share.

= Target price in five years / (1+ Cost of equity)^5

Value per share
= 30.46 / (1.1294^5)
= $16.58

At its current price of $49, this would again suggest an over valued stock. Here again, though, you are assuming that Amazon in five years will resemble a specialty retailer today in terms of risk, growth and cash flow characteristics.


http://zonecours.hec.ca/documents/A2009-1-1877347.ch18-earning-multiple(1).pdf