How is a P/E multiple used? The Price/Earnings Multiple Enigma

 

How is a P/E multiple used?  The Price/Earnings Multiple Enigma

https://myinvestingnotes.blogspot.com/2009/11/how-is-pe-multiple-used.html

Summary

The article from November 2009 explains the Price-to-Earnings (P/E) ratio and its variants as fundamental tools for stock valuation. Key points include:

1. Definition and Calculation:

   • The P/E ratio is calculated as the market price per share divided by earnings per share (EPS).

   • The trailing P/E uses historical (past year or last four quarters) EPS.

   • The forward P/E uses projected future EPS, which incorporates growth expectations.

2. Usage and Interpretation:

   • P/E reflects the premium investors are willing to pay based on a company’s future growth prospects.

   • It helps assess whether a stock is overvalued or undervalued, but must be compared within context (industry, growth rates, management quality).

   • A higher P/E may indicate higher expected growth or superior company fundamentals, not necessarily overvaluation.

3. Limitations of Historical P/E:

   • Trailing P/E fails to capture recent events (e.g., mergers) or future expectations, making forward P/E more relevant for investment decisions.

4. Introduction to PEG (Price/Earnings-to-Growth) Ratio:

   • PEG refines P/E analysis by dividing the P/E ratio by the expected earnings growth rate (e.g., over the next 2–3 years).

   • A lower PEG suggests a more attractive investment. A rule of thumb:

     • PEG < 0.5: Undervalued

     • PEG = 1: Fairly valued

     • PEG > 2: Overvalued

5. Important Caveats:

   • P/E cannot be used for loss-making companies (no earnings).

   • Qualitative factors (transparency, management quality) influence P/E multiples.

   • Comparisons should account for industry differences (e.g., utilities vs. tech).

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Discussion and Commentary

The article remains largely relevant today, as P/E and PEG are still widely used in equity analysis. However, some nuances and modern contexts can be added:

Strengths of the Article:

• Clarity on Forward vs. Trailing P/E: It correctly emphasizes that forward P/E is more meaningful for investment decisions, as markets are forward-looking.

• Context Matters: It highlights that P/E cannot be viewed in isolation—industry dynamics, growth rates, and qualitative factors must be considered.

• PEG as a Refinement: Introducing PEG helps adjust for growth, addressing a key limitation of P/E.

Limitations and Additional Considerations:

1. Earnings Manipulation: Both trailing and forward P/E rely on reported or projected EPS, which can be distorted by accounting practices or one-time items. Analysts often use adjusted EPS to mitigate this.

2. Interest Rate Environment: The article briefly mentions macroeconomic factors but does not deeply explore how interest rates affect P/E multiples. In low-rate eras, higher P/Es are more common (and vice versa).

3. Sector Exceptions: While P/E works for most sectors, it is less useful for capital-intensive, cyclical, or high-growth companies (e.g., early-stage tech) where earnings may be volatile or negative. Alternatives like P/S (Price-to-Sales) or EV/EBITDA may be preferred.

4. PEG’s Shortcomings: PEG assumes a linear relationship between P/E and growth, which may not hold for very high or low growth rates. It also depends on the accuracy of growth projections, which are often unreliable.

Modern Context:

• With the rise of FAANG-style tech stocks and unicorns, many investors now tolerate high P/Es (or negative earnings) based on disruptive potential, network effects, or scalability, challenging traditional P/E frameworks.

• Quantitative easing (post-2008) and low-interest-rate regimes have pushed P/E multiples higher globally, making historical averages less reliable benchmarks.

• ESG (Environmental, Social, Governance) factors are increasingly priced into multiples, affecting investor perception beyond pure earnings growth.

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Conclusion

The article provides a solid foundational understanding of P/E and PEG ratios, emphasizing their utility and limitations. While its core principles endure, investors today must also consider macroeconomic conditions, sector-specific nuances, and alternative metrics—especially in markets dominated by growth and innovation. P/E remains a starting point for valuation, but a holistic approach combining quantitative metrics with qualitative judgment is essential.