1. The Price/Earnings Ratio P/E Ratio

2. 2 What everybody knows about the P/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!!!

3. 3 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?

4. 4 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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6. Price 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.

7. Price 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

8. Price 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? –P 0 = P/E x E –P 0 + 23 x $1.13 = $26.

9. Price 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.

10. 10 Using 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

11. 11 Compare 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? Source: Morningstar

12. 12 Compare 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 be P = Present Earnings x Earnings Growth x future P/E = $5.40 x (1.06)**5 x 12.5 = $90 Corresponds 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

13. 13 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

14. 14 Compare the market to reality Source: Robert Shiller You are here 50 yr average 35%

15. 15 What Drives P/E? Earnings growth Business cycle Inflation Interest rates Investor exuberance/depression It is all about perceived future expectations!

16. 16 The End