Relative PE Ratios

 

Relative PE Ratios

 

Relative price earnings ratios measure a firm’s PE ratio relative to the market average. It is obtained by dividing a firm’s current PE ratio by the average for the market.

 

Relative PE = Current PE ratio (firm) / Current PE ratio (market)

 

Not surprisingly, the distribution of relative PE ratios mimics the distribution of the actual PE ratios, with one difference – the average relative PE ratio is one.

 

To analyze relative PE ratios, we will draw on the same model that we used to analyze the PE ratio for a firm in high growth, but we will use a similar model to estimate the PE ratio for the market. Brought together, we obtain the following.

Note that the relative PE ratio is a function of all of the variables that determine the PE ratio – the expected growth rate, the risk of the firm and the payout ratio – but stated in terms relative to the market. Thus, a firm’s relative PE ratio is a function of its relative growth rate in earnings per share (Growth Ratefirm/Growth Ratemarket), its relative cost of equity (Cost of Equityfirm/Cost of Equitymarket) and its relative return on equity (ROEfirm/ROEmarket). Firms with higher relative growth, lower relative costs of equity and higher relative returns on equity should trade at higher relative PE ratios.

There are two ways in which they are used in valuation.

• One is to compare a firm’s relative PE ratio to its historical norms; Ford, for instance, may be viewed as under valued because its relative PE ratio of 0.24 today is lower than the relative PE that it has historically traded at.
• The other is to compare relative PE ratios of firms in different markets; this allows comparisons when PE ratios in different markets vary significantly.

For instance, we could have divided the PE ratios for each telecom firm by the PE ratio for the market in which this firm trades locally to estimate relative PE ratios and compared those ratios.

Illustration:

Comparing Relative PE ratios for automobile stock – December 2000

In December 2000, the S&P 500 was trading at a multiple of 29.09 times earnings. At the same time, Ford, Chrysler and GM were trading at 7.05, 8.95 and 6.93 times earnings, respectively. Their relative PE ratios are reported.

Relative PE for Ford = 7.05 / 29.09 = 0.24

Relative PE for Chrysler = 8.95 / 29.09 = 0.30

Relative PE for GM = 6.93 / 29.09 = 0.24

Does this mean that GM and Ford are more under valued than Chrysler? Not necessarily, since there are differences in growth and risk across these firms. In fact, Figure 18.13 graphs the relative PE ratios of the three firms going back to the early 1990s. In 1993, GM traded at a significantly higher relative PE ratio than the other two firms. In fact, the conventional wisdom until that point in time was that GM was less risky than the other two firms because of its dominance of the auto market and should trade at a higher multiple of earnings. During the 1990s, the premium paid for GM largely disappeared and the three automobile firms traded at roughly the same relative PE ratios.

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