Four ways to use the PE ratio by SG Value
Price to Earnings ratio (PER) is arguably one of the most basic metric of valuation for a fundamental analyst. It is simply a ratio of a company’s current share price compared to its per-share earnings. While this is simple to understand, it can be over simplistic at times. There are many different ways of interpretation and variations which we can apply to this ubiquitous metric.
Price to Recurring Earnings
The net profit of companies may contain one-off charges which may distort the true representation of the business. One-off charges can be in the form of profit or losses and a value investor typically would not pay for such arbitrary items. By stripping out such charges, investors will get a better picture of a company’s true core earnings which pertains to the business that he is actually interested in purchasing. Fair value gains booked by companies are a common item that can distort true earnings.
Price/Earnings to Growth (PEG)
This is obtained by dividing your PER by the growth rate of earnings (Annual EPS Growth). This metric is more relevant in comparing growth companies. While a high PER might indicate that a stock is more expensive, factoring in the company’s growth rate might paint a different picture. To give a simple example, a stock with a 10% higher PER (than another stock) may instead have a 50% higher growth.
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P/E over time
The common application of PER is to compare it with an industry average in order to determine if a stock is relatively undervalued compared to its peers. Another form of comparison would be to compare the current PER against the historical PER of the company. For example, a company trading significantly below its average historical PER can be argued to be undervalued. Arguments are often made based on the standard deviation of its current PER – if something is -2SD away from the mean, it can be said to be more undervalued.
P/E over a cycle (Shiller P/E)
The Shiller P/E eliminates fluctuations of PER caused by variations in profit margins during business cycles. This is relevant for firms in cyclical industries such as semiconductors, steel, construction and some forms of luxury goods. To calculate the Shiller P/E, find the earnings of a company over the past cycle. Adjust them for inflation and find their average. Your Shiller P/E would be the ratio of the current price to that average earnings figure. Cyclical companies may be trade at relatively low PERs even at the peak of profitability and seem undervalued; comparing their Shiller P/E might help to explain why this is so.
To my knowledge, these are the typical variations of PER. However, there is always room for innovation when it comes to analysis. Similar to PEG, one can use PER relative to any other comparable that one thinks is necessary – PE to Gearing, PE to Sales, and even for PEG, one can choose between historical growth and expected growth. The most important thing is to understand what the ratios really mean and their underlying limitations/assumptions.