The Price/Earnings RatioThe Price/Earnings RatioP/E RatioP/E Ratio

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What everybody knows about the What everybody knows about the P/E ratioP/E ratio

• Widely used stock measure• Definition: P/E = Price (in dollars /share) divided by

Earnings (in dollars/share)– Example: ExxonMobil (XOM) costs $84.26/share

and earned $6.80/share. – P/E = $84.26/$6.80 = 12.4– Often called “Price Multiple” or “Earnings Multiple”

• Used for valuing and comparing stocks• Relatively Simple!!!

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But wait: there’s more…But wait: there’s more…• Which P/E did you have in mind?

– There are lots of definitions, and they are different– What share price to use? Which earnings to use?

• What’s a good P/E? – How do I know if a P/E is too high, low, or just right?

• How do I use it?• What if E bounces around a lot?

– What about one-time windfalls?– What if the company is losing money?

• What’s the P/E of the whole stock market?– Is it safe to go into the water yet?

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What is a good P/E for a Stock?What is a good P/E for a Stock?

In general, it depends …– Fast growing companies trade at higher P/E, but often

risky. – Slow growing companies trade at lower P/E, but often

safer. – The higher the P/E, the more “speculative” the

investment. – Exceptions: Intel (P/E=22), GM (P/E=7). Which is safer?

Super Big Caveat– Stockholders may never enjoy earnings squandered or

expropriated by management

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Price Earnings Valuation MethodPrice Earnings Valuation Method

• The price earning ratio (PE) is a widely watched measure of how much the market is willing to pay for $1 of earnings from a firm.

• A high PE has two interpretations:– A higher than average PE may mean that the

market expects earnings to rise in the future.– A high PE may indicate that the market thinks

the firm’s earnings are very low risk and is therefore willing to pay a premium for them.

Price Earnings Valuation MethodPrice Earnings Valuation Method

• The PE ratio can be used to estimate the value of a firm’s stock.

• Firms in the same industry are expected to have similar PE ratios in the long run.

• The value of a firm’s stock can be found by multiplying the average industry PE times the expected earnings per share.

P/E x E = P

Price Earnings Model: ExamplePrice Earnings Model: Example

• The average industry PE ratio for restaurants similar to Applebee’s is 23. What is the current price of Applebee’s if earnings per share are projected to be $1.13?– P0 = P/E x E

– P0 + 23 x $1.13 = $26.

Price Earnings Valuation MethodPrice Earnings Valuation Method

• Advantages:– Useful for valuing privately held firms and

firms that do not pay dividends.

• Disadvantages:– By using an industry average PE ratio, firm-

specific factors that might contribute to a long-term PE ratio above or below the average are ignored.

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Using the P/EUsing the P/E• P/E normalizes price and earnings,

allowing direct comparison - How would you like to price apples? Dollars per basket? Or dollars per pound?

• Compare a stock to…– its history– its future– its close peers– its industry– the market

• Compare the entire market to reality

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Compare a stock to its historyCompare a stock to its history

• Median P/E– Definition: Mid value of a series of

annual P/E values– Represents “typical” value for a stock’s

P/E– Useful for comparing historical and

current values

• E.G. – XOM 10-year median P/E = 18.1, but

current TTM P/E = 11.9– Should we buy?

XOMYear P/E1997 18.21998 28.01999 35.82000 19.12001 18.02002 21.72003 13.02004 13.22005 9.82006 11.6

Median 18.1TTM 11.9

Source: Morningstar

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Compare a stock to its futureCompare a stock to its future• What will XOM trade for in 5 years?

– (If I knew, I wouldn’t tell you)– Hard to forecast Price all by itself– Easier if we separate into 2 parts: Earnings, and P/E ratio

• Forecast from Value Line– XOM earnings will grow slower in the future, 6%/year vs.

14%/year over last 10 years– XOM P/E will be 12.5, lower than historic 18.1

• Therefore, in 5 years, XOM will price will beP = Present Earnings x Earnings Growth x future P/E = $5.40 x (1.06)**5 x 12.5 = $90Corresponds to 3% annualized total return

• Is XOM expensive or cheap?• Note: ValueLine “normalizes” or smoothes current E by averaging

over last 3 years before forecasting future E

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Using the P/E cont.Using the P/E cont.• Compare a stock to its peers

– XOM P/E = $84.26/$6.80 = 12.4 – Shell Oil P/E = $76.70/$8.30 = 9.2– Is Shell “cheaper” than XOM?

• Compare a stock to its industry– Average current P/E of oil cos. is 10.0 (ValueLine)

• Compare a stock to the market– Relative P/E: Divide a stock’s P/E by P/E of overall

market (as represented by S&P500 or other index)– Allows for comparison with market at present and over

time– E.G. XOM P/E (12.5) / Market P/E (19.5) = 0.64

Year 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006P/E 13.0 15.8 15.3 16.7 13.9 15.3 18.0 26.5 32.3 17.3 18.9 23.4 14.1 11.7 10.9 10.0

Rel.P/E 0.83 0.96 0.90 1.10 0.93 0.96 1.04 1.38 1.84 1.12 0.97 1.28 0.80 0.62 0.58 0.54

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0

5

10

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20

25

30

35

40

45

50

1860 1880 1900 1920 1940 1960 1980 2000 2020

Year

Pric

e-E

arni

ngs

Rat

io

1901

1929

1966

2000

Price-Earnings Ratio

1981

1921

Compare the market to realityCompare the market to reality

Source: Robert ShillerYou are

here

50 yr average

35%

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What Drives P/E?What Drives P/E?

• Earnings growth

• Business cycle

• Inflation

• Interest rates

• Investor exuberance/depression

It is all about perceived future expectations!

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The EndThe End