Market Metrics: Understanding P/E Ratios

If you’ve started dabbling in the markets, you’ve likely come across the term “price-to-earnings ratio” or simply “P/E.” And if you’re anything like I was when first starting out, you’re also wondering what the heck it means.

youngInvestorsB.pngThe quick answer is that it’s the relationship between a company’s current share price and its earnings per share (hence price divided by earnings).

What you should do with this number is a bit more involved, but a lot more important.

P/E ratios are vital when evaluating a stock because they provide a sense of how a company is being valued by the investment community. Investopedia explains that the metric shows just “how much investors are willing to pay per dollar of earnings,” adding that “in general, a high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E.”

The specifics aren’t so simple.

To properly apply a P/E ratio when making a stock-buying decision, you also have to understand the nuances.

For one, there are two types of P/E ratios that typically get thrown around — “trailing” and “forward” — and they’re two very different animals. To get a sense of each, let’s walk through an example using everyone’s favorite fast-food pleasure: McDonald’s (MCD).

On Aug. 19, the struggling Golden Arches closed at $95.48 per share — that’s the “P” in your P/E ratio. Now, all we have to do is find the “E.”

For trailing P/E — “trailing” refers to the “trailing 12 months” — you compare the price to the total earnings of the most recent four quarters. McDonald’s past four quarterly EPS results are seen in the table below.

Month of Quarter End Earnings Per Share
September 2012 $1.43
December 2012 $1.38
March 2013 $1.26
June 2013 $1.38
Total $5.45

So, your trailing P/E ratio is $95.48 divided by $5.45, which gives you a trailing P/E ratio of 17.6.

And when the next quarter is reported in October, the oldest quarter’s number will be dropped.

The company’s forward P/E is a bit different, as you used Wall Street analyst expectations for earnings for the upcoming year. For McDonald’s, 2014 earnings are expected to total $6.11 per share. Substitute that in for the “E” in our equation, and you get a forward P/E of 15.6.

The fact that the forward P/E is lower than the trailing is normal, as Mark Hubert at The Wall Street Journal explains. The three main reasons:

  1. Corporate earnings usually increase each year.
  2. Analysts’ estimates use “operating earnings” — a “looser category” than the actual reported earnings used in the trailing metric.
  3. Wall Street analysts’ predictions tend to be overly optimistic.

“These three factors conspire to make forward-looking P/Es 24% lower on average than those based on trailing earnings,” Hulbert wrote, citing a study by Cliff Asness and Anne Casscells on the two types of P/Es using data covering nearly three decades.

And that’s why you should be sure not to compare a trailing P/E ratio to a forward one, as the metrics each tell very different stories.

Instead, the best way to use either P/E ratio is to compare it against a similarly calculated P/E ratio … say, of companies in the same industry, or the market in general.

Going back to McDonald’s, an obvious comparison would be to other fast-food chains, as seen in the table below. Just remember to compare trailing to trailing and forward to forward.

Company Ticker Trailing P/E Forward P/E
McDonald’s MCD 17.6 15.6
Wendy’s WEN 33.8 28.8
Burger King BKW 24.9 21.1
Yum Brands YUM 23.4 18.9

You also can compare the stock’s P/E to its own historical valuations. While MCD’s ratios look low — meaning it has lower expected growth compared to its peers, and is often referred to as “looking cheap” — the trailing P/E actually isn’t all that great when you compare it to McDonald’s historical trailing P/E, as shown by this graph, courtesy of YCharts:

ycharts_chart (42)

The stock’s five-year average for a trailing P/E ratio is 16.6, while the range goes from 13 — hit in October 2008 — to 19.72, which came in late 2011 amid a 30% run for MCD that year.

Right now, that means that McDonald’s looks undervalued compared to its peers, but slightly overpriced compared to its historical valuation. But why should you care?

Well, if you think McDonald’s P/E is too low, you might buy the stock based on the theory that other investors eventually will discover that company’s “true” value, driving up the price and thus “normalizing” the P/E. On the flip side, if you think it’s currently overvalued, you would avoid it on the assumption that the “true” value is lower than current prices, and that prices eventually will reflect that by heading lower.

One huge caveat, though: Some stocks always trade at a premium to the earnings they produce. Case in point, Netflix (NFLX), whose $273 price tag is a whopping 340 times the company’s trailing earnings. That’s not out of the ordinary, as the company’s average P/E over the last five years is nearing triple digits, and it even hit a high of 669 earlier this year!

Thus, trying to use this valuation tool to analyze Netflix would be like trying to use a screwdriver to tie your shoe — and this also is the case for other historically high-P/E stocks like Amazon (AMZN) and Facebook (FB).

The bottom line: Understanding price-to-earnings ratios might not be useful for every stock analysis, but it’s a fine addition to your investing toolkit.

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Article printed from InvestorPlace Media,

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