Four Different Ways To Use The PE Ratio

Four Different Ways To Use The PE Ratio
Image source: Pixabay

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.

Einhorn’s Greenlight Drops -2.6% In Q3 As Equity Buyers Vanish [Full Letter]

David Einhorn's Greenlight Capital funds returned -2.6% in the third quarter of 2021, compared to a return of 0.6% for the S&P 500 in the same period. Longs detracted 4.5% in the quarter while shorts added 1.2% and macro added 1.0%, according to a copy of the letter ValueWalk has been able to review. SORRY! Read More

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.

Updated on

Previous article Facebook Inc vs Twitter Inc In Earnings
Next article Ariel Focus Fund: Top contributors Lockheed Martin and Microsoft
I developed my passion for investment management especially equity research at a relatively young age. My investment journey began when I was 20, at a point in time where markets were still recovering from the Global Financial Crisis. My portfolio started from money I saved over the past years and through working during the holidays. I was fortunate to have a good friend with common investing mentality to began my journey towards value investing. To date, we still research and invest in companies together, discussing valuations and potential risks of a company. To date, I manage a fund with a value investing style. Positions are decided upon via a bottom-up approach or smart speculation (a term I came up with when buying a stock for quick profit due to a mismatch in prices in the market due to takeovers/selling of a subsidiary or associate). Apart from managing my own portfolio, I enjoy sharing my research with family and friends, seeking their opinions and views towards the stock. Reading Economics in London, I constantly keep up with the financial news in Singapore & Hong Kong. Despite my busy schedule, it has not stopped me from enjoying other aspects of life. I enjoy a variety of activities in whatever free time I may have – endurance running, marathons, traveling, fine dining, whiskey appreciation, fashion. Lastly, I enjoy meeting new people, discussing ideas and gaining new perspectives towards issues in the world.

No posts to display