PE Ratio - Gaapifrs Clive Boddy web site by yurtgc548

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									The Price/Earnings Ratio
       P/E Ratio

     Dr. Clive Vlieland-Boddy
  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!!!
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   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?             3
  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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5
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.
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
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?
  – P0 = P/E x E
  – P0 + 23 x $1.13 = $26.
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.
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     10
  Compare a stock to its history
                                                             XOM
• Median P/E                                     Year          P/E
  – Definition: Mid value of a series of         1997         18.2
    annual P/E values                            1998         28.0
  – Represents “typical” value for a stock’s     1999         35.8
    P/E                                          2000         19.1
  – Useful for comparing historical and          2001         18.0
    current values                               2002         21.7
                                                 2003         13.0
• E.G.                                           2004         13.2
  – XOM 10-year median P/E = 18.1, but           2005          9.8
    current TTM P/E = 11.9                       2006         11.6
  – Should we buy?                             Median         18.1
                                                 TTM          11.9
                                               Source: Morningstar

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  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 12
                   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 2006
    P/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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     Compare the market to reality
                       50                                                                  2000
                       45        Source: Robert Shiller
                       40
                                                                                                  You are
                                                                                    1981
                                                                                                   here
                       35                                    1929
Price-Earnings Ratio




                       30
                                               1901                          1966




                                                                                                  35%
                       25   Price-Earnings Ratio

                       20

                       15                             1921

                       10                                                                   50 yr
                                                                                           average
                        5

                        0
                        1860       1880        1900   1920          1940   1960     1980   2000         2020
                                                                    Year
                                                                                                          14
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 End



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