**The Price to Earnings Ratio**

Jim Graham

When most investors think about the fundamental value of a company, they usually think of the price to earnings ratio. The P/E ratio tells you how much you are paying for each dollar of a company's earning (profit). It is popular because it's easy to understand, but in some situations it can be misleading and is not a substitute for real fundamental research. Still it is a useful tool for valuing an individual stock and can also be used to help you form an opinion on the likely future direction of the stock market as a whole.

**Understanding the Price to Earnings Ratio**

The P/E ratio is simply a mathematical calculation. It is the current price of one share of stock divided by earnings per share.

The first thing to understand about the P/E ratio is that it is designed to value a share of stock, not a company, and stocks are priced per share. The P/E ratio tells you what the market is willing to pay right now for anticipated future earnings, assuming that the earnings remain constant into the future. A stock that has a P/E ratio of 15, for example, tells you that it will take 15 years of the company's earnings at the current rate to add up to your original purchase price.

To see if a stock is over- or under-valued, the first step is to compare its current P/E ratio to its past P/E ratio. This will give you an idea of how cheap or expensive the stock is relative to the how it has been valued in the past.

The next step would be to compare its P/E ratio to the ratios of other companies in the same industry. Companies in the same industry tend to have similar P/E ratios. If it is considerably higher or lower than its peers, you will want to do additional research to see why that it is.

**When the P/E ratio is Low**

Low-P/E stocks are not necessarily a good value. If you were to buy a few stocks with low P/E ratios you may soon discover the reasons they were so cheap. A low P/E ratio usually indicates that investors expect little to no growth in a company's earnings in the future, or possibly even a drop in earnings in the future.

Companies in some industries, homebuilders for example, historically have very low P/E ratios. So a home builder that you see with a P/E of 10 might actually be an all-time high for that company indicating it might be overvalued. It is only when comparing its P/E ratio with its peers in the same industry that you can see how a company is valued compared to other companies in its industry.

Rather than indicating a bargain, an extremely low P/E ratio is often a sign of financial trouble or other problems with the company or industry. Investors using the P/E ratio to find potential bargains, often called value investors, must follow up and do extensive research to completely understand the company and the industry it operates in before making any investment. In fact, if you were to buy all low P/E stocks without further research, you would probably just end up with a portfolio of underperforming stocks.

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**When the P/E Ratio is High**

Just as a low reading does not always mean a bargain, a high P/E ratio does not always mean a company is overvalued. There are many reasons investors might pay a premium for a company.

P/E ratios can be especially misleading when a company has recently posted a loss. Due to what are often temporary problems, a company's P/E ratio will be restated, often in concert with accounting charges that have to be taken. These companies will then show a high P/E ratio or in some cases may not even have a P/E ratio available. As long as the problem is only temporary, the P/E ratio typically reverts to more normal levels after a few quarters.

Let's look at a stock that is selling for $58 and earned 40 cents a share last year. That is exactly the current figure for United Parcel Service (Symbol: UPS). Its P/E ratio is 58/0.40 = 145, which is very high. It means that at the current earnings per share of 40 cents it would take you 145 years to get back the price you paid for the stock. While your advisor might recommend investing for the long term, 145 years would be just a bit too long for most of us.

Naturally, investors aren't really willing to wait that long. What is missing from this analysis is growth. Investors must expect a sharp increase in earnings relatively soon, certainly much sooner than 145 years from now.

You should be willing to pay a higher P/E ratio (calculated by current earnings) if you feel a company's earnings are going to grow in the future, since your payback time would be quicker. That is why a high P/E ratio doesn't always mean a stock is overvalued. To get a better reading, you should always bring in a company's expected growth rate. One way to do this is with a measure called PEG, the P/E ratio divided by the expected growth rate. This will tell you the amount investors are willing to pay for a stock's anticipated future earnings.

Of course, very few companies would have exactly the same earnings quarter after quarter. That is another reason you would like to adjust the P/E ratio by the expected change in earnings in the future. Those whose earnings per share are growing, and expected to continue growing, would justify a higher P/E ratio. Those with declining earnings should be lower.

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**Finding What P/E Ratio indicates "Fairly Valued"**

The best way to value a company is to use discounted cash flows to calculate the present value. Most investors prefer to use a simple rule of thumb, which is why the P/E ratio is so popular. But drawing the conclusion of how long it will take you to be "paid back" from the P/E ratio assumes the company is in a mature stage where earnings are constant.

When you use the discounted cash flows formula on a zero-growth company, you find that its fair P/E ratio is equal to 1/r, where r equals the discount rate (or rate of return you need to make the investment worthwhile). So if you require a rate of return of 10%, a fairly valued stock price for a mature company would have a P/E ratio of 10. Using a real interest rate of 2% (about the historical average) plus the 5-year treasury rate of 3.28%, and you would see that a fair P/E ratio would be around 19.

So the "number" for the P/E ratio that indicates a stock is fairly valued changes over time, and that change is driven by primarily by the rate of return that is being demanded by investors. Naturally, every investor will have slightly different personal requirements, but what we are really interested in is what the average required rate of return, which can also change over time.

As mentioned earlier the long-term historical real interest rate is around 2%. The real interest rate is the actual current interest rate minus the inflation rate. So the inflation rate is one of the biggest determinants of what a "fair" P/E ratio is. During the past few years, inflation has been extremely low (as well as interest rates), so an average P/E ratio around 20 would be fairly valued.

However, in the past year or so inflation has been increasing dramatically, led by increases in commodity prices, and a higher inflation rate means that investors will begin demanding a higher rate of return. That in turn will decrease the number at which the P/E ratio would be considered fairly valued. For example, an increase of just 1% in the rate of inflation should translate into a decrease in the "fair" P/E ratio from 19 to 16.

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**Calculating a P/E Ratio for an Index**

Just as you can calculate the P/E ratio for any individual stock, you can also measure the P/E ratio of any group of stocks. A broad market average like the S&P 500, after all, does have a price. You probably see it quoted, along with how much it went up or down, every trading day. And to get an earnings figure, you simply add up the earnings for all 500 stocks in the index. So what would be a reasonable P/E for such a broad market? Not surprisingly, the answer is "it depends".

The current P/E ratio for the S&P 500 is based on "as reported" or GAAP earnings (calculated using Generally Accepted Accounting Principals). As of June 30, some companies have already reported, and for others we will need to use the past quarter. The S&P 500 closed at 1280 on June 30, which divided by the combined earnings of $64.65, gives a P/E ratio of 19.80.

But just as there is no single "right" P/E for a stock, there is no single number where you can say the market is fairly valued. The old rule of thumb was that a normal range for the P/E ratio was between 10 (below this would be undervalued) to 20 (over this would be overvalued). Notice that the current P/E of 19.80 is very close to the 20 level that has traditionally been the level where stocks were considered overvalued.

We already saw how the rate of return you require can be a big factor in judging a fair P/E ratio. During periods of low inflation blue chip stocks can trade at P/Es two to four points above normal (for example, 20 instead of 16). So with low inflation and interest rates, P/E ratios of 20 or a little higher are sustainable.

Below is a graph that shows the historical level of the P/E ratio for the S&P 500 for the past 40 years. While it has mostly been just below the 20 mark the past few years, it has not fallen below the 10 mark for over twenty years, and hit an incredible 45 or so at the top of the tech bubble.

The most interesting thing I found was that the current P/E ratio of 19.8 is very close to what we calculated earlier would be a fair P/E using a rate of return of 5.28% (the current 5 year treasury rate plus the actual historical real interest rate of 2%).

Inflation has been picking up in the past year and that would imply that the P/E ratio of the market should start falling. The easiest way for that to happen is if the price (in the numerator of the ratio) goes down. But that doesn't mean the market has to fall further. It is possible that the P/E ratio could fall as the stock market is rising as long as earnings in the future are expected to be higher than they are today.