In equity analysis, price-earnings is the most common ratio calculation.
Used to analyze most investment styles, it is a cornerstone of value investing.
Today we look at the concept and how to use it.
Note that the examples below use real data as at December 18, 2017 in US dollars.
Price-Earnings Ratio
Price-earnings (also seen as Price/Earnings or P/E) is a widely used fundamental.
To calculate, simply divide a company’s earnings per share (EPS) into its current share price. That said, most stock ticker services provide P/E ratios in their quotes and financial information. So you normally need not calculate.
For example, Wells Fargo & Company (stock symbol: WFC) is a financial services company that operates primarily in the United States. On December 18, 2017, WFC traded at $60.99 per share.
WFC has trailing 12 month diluted EPS of $3.87. Therefore, its P/E ratio is 15.76.
Very simple to calculate (or pluck from the Yahoo Finance website).
But is WFC’s P/E ratio good or bad? I have no idea. And sadly, Yahoo Finance does not provide its opinion.
Analysts and investors can never consider data or ratios in isolation. We need to look at comparative data.
Compare a Company Against Itself
That may be the company’s historic or expected future P/E ratios.
Look at Historic Results
How does the current P/E ratio compare with the same company’s over time?
If you knew that the average P/E over the last decade was 11, yet now it is 15.76, that should give pause. Is the stock overvalued? Or perhaps it has added a new product line or market, corporate acquisition, cost cutting measures, etc. Changes that will increase future EPS to bring the P/E back in line.
Conversely, if the historic average P/E for WFC is 20, perhaps the stock is undervalued. Or maybe the lower than historic P/E ratio reflects investor sentiment that trouble is ahead for the bank.
Yet again, it is the qualitative analysis that helps determine potential versus pitfall.
And Future Expectations
While the past is interesting, you need to always focus on the future.
This is true for any analysis, not just the P/E.
WFC current EPS for the trailing 12 months is $3.87. For next year, per Yahoo Finance data, the estimated EPS is $4.32. This results in a Forward P/E ratio of 14.11.
This may be a positive. As the stock price is a constant at December 18, a lower Forward P/E must mean that EPS is expected to increase next year (as it does). Usually, increasing EPS is a good thing.
Compare Against External Measures
As well as comparing a company to its past performance and futures estimates, you should consider relevant outside measures. Key competitors, it’s industry, and sector of operations. Perhaps even to the market as a whole.
Note: Depending on the market, industry, or specific sector, you may or may not be able to find P/E data in aggregate. If index data is not available, a useful little trick is to substitute comparable mutual or exchange traded index funds. Funds typically provide P/E (and/or other) ratios paralleling their tracked indices in the performance data.
With WFC, let us compare its P/E against the market as a whole. Then its industry and key competitors.
Compare to Broad Market
Try to find a broad market that is relevant to your stock.
WFC operates, and is listed, primarily in the U.S. It makes more sense to compare WFC ratios to a broad U.S. index than Hong Kong’s Hang Seng or Germany’s DAX.
WFC is a significant component of the S&P 500, a broad U.S. market index. Currently, WFC is the 12th largest component of the S&P 500, representing about 1.17% of the index. That should be an appropriate benchmark.
If we have index data, we can compare directly to the index. And the S&P 500 data is often available to retail investors.
But let us assume, for demonstration purposes, we cannot get direct index data. We can compare WFC to (say) the iShares Core S&P 500 ETF (symbol: IVV) as it reflects the market index closely. IVV trades at a P/E of 23.77 versus WFC P/E of 15.76 as at December 18.
Note that in comparison the actual S&P 500 trades about 25 currently, with slight variances between reporting companies due to measurement dates.
A lower than market P/E ratio may indicate WFC is undervalued. If WFC traded at the average 23.77 market multiple, you would expect a share price near $91.99 ($3.87 EPS * 23.77). As it trades at $60.99, there is potential for appreciation.
However, WFC is a financial services company. Relative stable and lower risk (with lower expected returns) than other components of the S&P 500. For example, the more volatile Information Technology sector makes up 24% of the index, whereas the less risky Financials are 14%. I am not sure a bank should trade at the same premium as Apple or Facebook.
While comparing P/E of a company to the market as a whole is fine, it can become a bit of an apples an oranges analysis. Probably better to drill down to where we can (hopefully) compare apples to apples.
Drill Down to Industry P/E
Let us compare WFC to iShares U.S. Financial Services ETF (symbol: IYG), a sector index fund. As the name indicates, its focus is more on companies such as WFC. In fact, WFC is the fund’s third largest holding at 8.64% of total assets.
The P/E ratio for IYG is 20.32 versus WFC’s 15.76. That too indicates room for price appreciation in WFC. However, just be careful. Even though we are comparing WFC against companies in the same industry, we must consider size and stability.
WFC is a relatively large company in the sector. As we saw above, the fund’s third largest holding. That means there are plenty of smaller, less stable, financial services companies in the index. These companies are typically riskier, so investors demand higher P/E multiples. While we drill down to the industry, probably prudent to also compare WFC to its true peers.
And Direct Competitors
The top five holdings in IYG are: JPMorgan Chase (symbol: JPM) at 11.87%; Bank of America (BAC) at 9.15%; WFC at 8.64%; Visa (V) at 6.59%; Citigroup (C) at 6.40%. If we exclude Visa, the remaining banks are comparable.
As at December 18, each bank has the following P/E ratio: JPM 15.39; BAC 16.89; WFC 15.76, C 14.53. At this level, the market is pretty efficient and all companies trade at similar multiples.
As you perform your qualitative analysis, you will determine if WFC should be trading at the same (or higher) multiple than BAC. If so, based on earnings of $3.87, you might buy WFC in the expectation that its price will rise to equilibrium with BAC’s P/E and trade at $65.36. An increase from where it sits now at $60.99.
Or you may assess that it ranks on par with C at a 14.53 P/E. If so, you may expect a price decline in WFC to $56.23.
Not the easiest task in the world to determine whether a stock is a buy or sell from its P/E ratio.
The data is actually of more use than you may think after reading the preceding on WFC. However, as with all investment analysis, it is the qualitative side that brings clarity to the quantitative calculations. And that qualitative expertise comes with time and experience.
Next up, we will consider some additional potential problems with P/E ratios.
