How is a P/E multiple used?

The Price/Earnings Multiple Enigma

If the Price to Earnings Multiple (P/E) were to be judged by usage, it wins hands down compared to any other valuation metric. It is easy to compute, can be applied across companies and across sectors, with a few exceptions. What is this ratio, how is it computed, and how to use it are questions to which you will find answers in this section.

What is a P/E multiple?
The P/E multiple is the premium that the market is willing to pay on the earnings per share of a company, based on its future growth. The ratio is most often used to conclude whether a stock is undervalued or overvalued. The P/E is calculated by dividing the current market price of a company's stock by the last reported full-year earnings per share (EPS). In effect, the ratio uses the company's earnings as a guide to value it. The P/E thus computed is also known as the trailing or historical P/E since it uses the trailing (historical) EPS in its calculations. With the advent of quarterly results, it is also possible to compute P/E, based on the earnings of the latest four quarters’ EPS. This is known as trailing twelve months P/E.

A variant of the P/E - called the forward P/E - has also been developed wherein the current market price of the stock is divided by the expected future EPS. The attempt to study P/E ratios in this manner reflects the effort to factor in the expected growth of a company.

Since stock market valuations factor in the future expectations of the market, a P/E multiple computed using historical earnings can at best be of academic value since it does not factor in the future growth in earnings. It fails to capture events that may have happened after the earnings date. For example, suppose a merger happens after the earnings have been declared, a P/E multiple based on the historical P/E will fail to capture this event in the EPS whereas the price would reflect it, creating a distortion.

The forward P/E is popularly used to find out if the premium the market is willing to pay on the earnings is line with the growth expectations. For example, the market price of Stock A is Rs 1,000, with a P/E multiple of 30 based on historical earnings. Assuming an earnings growth of 50%, the one year forward P/E changes to 20, which means the market is willing to pay 30 times its historical earnings and 20 times its one-year forward earnings.

For an investor it makes much more sense to look at the forward P/E for taking an investment decision. Each investor would have his or her own expectations regarding the future earnings growth. To that extent the forward P/E for a particular stock will vary from investor to investor.



How is a P/E multiple used?
P/E multiples reflect collective investor perception regarding a company's future. This perception is a function of various factors, like industry growth prospects, company’s position in industry, its growth plans, quantum change expected in sales or profit growth, quality of management, and other macroeconomic factors like interest rates and inflation.

Is a stock trading at a P/E of 30 more expensive than a stock trading at a P/E of 60? Such a wide variation in P/E multiples can be owing to a few reasons. If the companies are in the same industry, it could be that the company with a high P/E may be one with superior size and financials, with better prospects or even better management. The market expects this stock to outperform its peers. If they are from different industries, it could also be due to different growth prospects. For example, an energy utility will have a more sedate earnings profile than say a software company.

Besides different expectations regarding future earnings growth, some of the difference in P/E can also be attributed to the disclosures made by the management to their shareholders. Hence, qualitative factors like transparency, quality of management also impact a stock's P/E.

Stock prices, in isolation do not give any indication whether the stock is undervalued or overvalued. They have to be viewed along with the company's future prospects to arrive at any conclusion. Generally, higher the expected growth in a company's earnings, higher is the P/E multiple that it attracts in the market. The time period used for P/E calculations depends on the investment horizon of the investor and would be different for each investor. However, P/E multiples cannot be applied to loss making companies since they do not have any earnings.


Price to Earnings Growth Multiple (PEG)
The PEG multiple takes the P/E analysis to the next stage. Since P/E ratios are computed based on historic earnings, they project an inaccurate picture of the future. The PEG multiple uses expected growth in earnings, to give investors additional information. The PEG divides the historical P/E ratio by the compounded annual growth rate of future earnings. Generally, the compounded earnings growth is calculated using the forecasted earnings for the next two-three years.

For example, if a company is quoting at a P/E of 60 based on historic earnings and the compounded annual growth rate of its earnings for the next three years is 20 per cent, then its PEG is 3.

The lower the PEG, the more attractive the stock becomes as an investment proposition. It is obviously more appealing to buy a stock on a P/E of 20 whose earnings are growing at 50 per cent than to buy a stock on a multiple of 50 whose earnings are growing at 20 per cent. As a thumb rule, stocks quoting at a PEG multiple below 0.5 are considered to be undervalued, 1 to be fairly valued, and 2 to be overvalued.


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