One of the simplest and most commonly used ways to determine the value of a publicly-traded business is by checking the company’s P/E ratio. The formula is very simple, it is simply the current price (P) divided by earnings (E). At first glance, this seems simple enough, but often it is not as simple as it appears.
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The company’s stock price is reported in real time on most financial websites that offer a quoting service. But businesses only report earnings on a quarterly basis. Consequently, when we are between the quarterly reports, we really don’t have a precise earnings figure upon which to calculate the P/E ratio.
As a result, not all financial websites report the P/E ratio on the same basis. Some will report P/E ratios based on trailing twelve month earnings (ttm), others might report the P/E ratio based on forward earnings, and some will report P/E ratios on both.
Unfortunately, this can lead to a common mistake that is often made when looking at a P/E ratio on a quoting service. The price or numerator (the top number) is current and accurate. However, it is the earnings or the denominator (the bottom number) that can be problematic. If you are using trailing earnings (ttm), your denominator might be too small, thereby causing the P/E ratio to be higher than it really is. If you are using forward earnings, they might not manifest as expected, thereby causing the denominator to be too large, which makes the P/E ratio calculation look lower than it truly is.
Consequently, FAST Graphs calculates the current P/E ratio by taking a blended approach. Admittedly, like the trailing or forward calculations, a blended P/E ratio might not be perfectly accurate either.
However, we do believe that a blended P/E ratio calculation will be more precise than the two other alternatives. Trailing twelve months’ earnings can be getting stale, especially when we are in the late innings of the next quarter. Earnings estimates out to the next year may be too optimistic. However, giving credit to the current quarter’s earnings estimates are more likely to be realistic or close to it.
Here it is important to note that it takes companies approximately 45 days after the close of the fiscal quarter before the actual numbers are reported. Consequently, it is possible that a trailing twelve month number might be 4 ½ months old.
Therefore, by blended P/E ratio, we mean a weighted average of the most recent actual reported earnings plus the closest quarterly forecast earnings. This gives the most weight to the past “actual” reported earnings, but also includes an appropriate consideration of the company’s continuing earnings power post their last report. For most companies, the blended P/E ratio calculation will be using a moderately higher denominator than trailing twelve months. In other words, we believe the blended P/E ratio calculation is based on a more current level of earnings.
Article by F.A.S.T. Graphs