Every now and then we get a question submitted to us by members about the P/E ratio. The question usually takes one of two forms.

1 – “I look at three different sites and each one has a different P/E ratio. What gives?”

2 – “Your previous answer referenced a P/E of X, why does blank.com show a P/E of 200?”

Both are very fair questions and a great example of how retail investors can be disadvantaged from the start, without even knowing it. But first, lets take a step back and look at what the P/E ratio actually is.

Price-to-earnings (P/E) ratio

The P/E ratio does sound relatively self-explanatory, but there is more to it than meets the eye. In essence, it is the current market price of a stock divided by the earnings per share (EPS). EPS is the net income per share at a company. The P/E is known as a relative valuation multiple, and can be used to compare a company to itself based on historical multiples or to how peers are trading today. If earnings are high relative to the price, you get a low P/E and in turn a stock that looks ‘cheap’. If earnings are low relative to the price, you get a stock that looks expensive. It gets a bit more convoluted past this point, as cheap stocks can be cheap for a reason and expensive ones deserving of a premium, but this is a conversation for another time. In general, the P/E ratio can be used as a quick and easy way to gauge whether you are getting a good deal on a company relative to the level of earnings it is generating.

The P/E can be further broken down into trailing earnings P/E ratios and forward P/E ratios. The trailing ratio takes the last twelve months of EPS (or last fiscal year depending on the data system) while the forward P/E looks at the EPS estimate a year ahead of time. One could develop their own estimate of what next year's earnings will look like, or simply use an average of analyst estimates for the next year in order to come up with the forward EPS number.  Whether or not it is trailing or forward, the numerator will still be the current market price.  The two forms then show that the P/E ratio can be either forward looking or backward looking, and this is where a lot of the problems with free data services can arise.

One company, multiple P/E’s

This issue stems more from the data feed being used and how they are automatically analyzing the data. Some feeds will use trailing twelve month numbers, others will use EPS as of the most recent year end and some may even take the most recent quarters EPS and annualize it. Going even further, some may use some type of forward estimate. Each of these methods can provide a very different price-to-earnings ratio so it is easy to see how this can be a frustrating and even discouraging experience for retail investors. Fortunately, the fix here is relatively easy. It is the second question that I find more troubling. 

Irrational P/E’s

In many cases, an investor will come across a P/E that has some sort of irrational number such as 200 times earnings. Certainly, there are some names that hold such lofty valuations, but these are more often the exception and the issue is that whatever data feed that is being used, is using trailing P/E ratios. At face value, this does not seem like a big deal, but the problem is that no one actually uses trailing P/E ratios when evaluating a stock. Unfortunately, since it is easy to reference and calculate it is often used by default, which makes many investors believe it is an appropriate tool to use. This acts as a disadvantage from the get-go and can also mean many interesting names get overlooked.

Why is the trailing P/E not overly useful? Because it looks at things that have already happened and are largely priced into a stock. Markets are not always perfect, but they are pretty quick to adjust to future expectations in earnings and if an investor is looking at trailing earnings, they are missing more than half the story. As an example, lets say a company reports EPS of $1 today and has a share price of $2. Tomorrow, they sign a deal where they will make an extra $9 over the year.  After this news, the share price jumps to $20 (arbitrary number chosen). An investor looking at the trailing P/E would see a P/E of 20 (20/1). This ignores the future earnings to which the stock has adjusted. In reality, a better picture of the valuation is a forward P/E of 2 (20/10).  So why use a trailing P/E at all? I think generally, when dealing with free services, it is just a cheaper and easier to find metric for the data service as analyst estimates can be harder to find. Trailing metrics can be useful in situations where a stock has little to no analyst coverage but the issue that it only considers the past still remains.  Unfortunately, if there are not forward estimates provided, most retail investors can be out of luck, but there is at least a way one can become more confident in the trailing P/E they are seeing. 

If you are looking at multiple P/E ratios showing different values, simply go to the income statement, which can be found through searching at www.sedar.com, pull up the income statement and find the EPS number from the last four quarters. When applied to the prevailing share price, it will help you confirm whether the data you are looking at is correct. It is a bit more tedious but can help save sleep at night. For the more involved investor looking for a forward estimate, many companies provide EPS guidance. One could use this guidance range to try and determine what the forward P/E will look like. It is not perfect, but it is likely good enough for most investors and the majority of analyst estimates are anchored to the guidance that a management team provides in the first place. Some data is better than no data, but in the case of a trailing P/E, if an investor does not fully understand what they are looking at, opportunities could be missed and mistakes might be made.