5.3 Price to Earnings Ratio

The Price Earnings Ratio divides the stock price by earnings per share (EPS).  This multiple can be used to identify the relative value of similar stocks.  There are three different types of P/E ratios commonly used in practice:

i.              P/E Ratio = Stock Price/Annual Earnings per Share (EPS)

ii.            Trailing P/E Ratio = Stock Price/EPS computed from the sum of last four quarters

iii.           Forward P/E Ratio = Stock Price/Forecast Earnings per Share

Relative valuation uses these ratios to rank similar stocks such that the lower the ratio the higher the ranking.  A ratio is defined relative to annual earnings measures of the number of years required to recover the current stock price from earnings if there is no earnings growth. 

The three types of price earnings ratios defined above vary in terms of the timeliness and relevance of the relative valuation ranking.  For example, the Trailing P/E Ratio provides more timely information because the Trailing P/E Ratio constructs annual earnings per share number from the most recent available four quarters. 

Role of Growth Forecasts

Stock prices reflect expectations about the future.  The Forward P/E Ratio is a refinement of the Trailing P/E Ratio because it incorporates expectations about future earnings into the analysis.  A potential weakness with this is that only the next year is taken into account, while a stock price will reflect earnings expectations about future years as well.  One refinement of the P/E ratio designed to incorporate this idea is the Price/Earnings to Growth Ratio (PEG) Ratio.  Here Growth is usually defined as the expected Growth over the next 5-years to overcome this problem.

Again, this ratio is interpreted relative to a similar stock or set of stocks in an industry.  All other things being equal, the stock with a lower PEG ratio is ranked higher than a similar stock with a higher PEG ratio.

We illustrate these ideas next for a small set of well known stocks with similar business models.

Tutor Reconciliation:  Proctor and Gamble (PG)

Step 1:  Refer to section 5.2 to bring up the Income Statement and Balance Sheet for Proctor and Gamble as described in section 3.2.  Be sure to select the August 13, 2010 10-K from the dropdown.  This is displayed at the bottom of the screen as follows:

We can reconcile Price Earnings Ratio by selecting the Consolidated Income Statement as follows (LHS of the screen):

Step 2:  Refer to the calculator part of the Valuation Tutor screen.  Click on Calculate and this has computed the Price Earnings Ratio from the following fields:

You can observe above the additional derived fields are:

Earnings per Share = $4.315

5-Year Growth Rate = 0.0963

Price = $64.050

Price to Earnings Ratio = $64.050/4.315 = 14.84

Expected EPS = 3.99 (Note: this is next year which can be a forecast decline even though the next five years is forecast to be positive 9.63%)

Price /E(EPS) = $64.05/3.96 = 16.05

PEG Ratio = 14.84/9.63

PE(E)G Ratio = 16.17/9.63

Step 3:  Where did these numbers come from?

Unfortunately in the financial statements there are many variations of the EPS!  For example, both the numerator Earnings, and denominator number of shares can take different values.  The main point is that so long as you are consistent across stocks then relative pricing is relevant.  However, this is one of those numbers where additional analysis is required.  The accountants realize this and full details are provided in the 10-K as well as the interactive statements.   

Valuation tutor software lets you quickly compare both sources:

In the LHS we have already got up the interactive consolidated income statement.  Now consider the bottom RHS of the screen.  If you click on the tab Company Filing you are taken immediately to the company filings as depicted below:

For the case of P&G they highlight directly “Computation of Earnings Per Share” (see above right hand side of the screen).  Clicking on this brings up the following complete reconciliation (rounded to nearest cent):

You can cross check with the interactive statement.  So the default number for EPS is the accounting basic net earnings per common share.