As one of the most commonly touted valuation metrics, people often quote P/E ratios without a second thought as to how they behave. The general perception is that high P/E ratios indicate an overvalued company or market, and low P/E ratios indicate an undervalued or perhaps "better" valued company or market. For some investors, adherence to this metric can be a major driver of investment decisions. P/E ratios are sometimes referred to as "earnings multiples," conveying the notion of how much investors are willing to pay for a given stream of earnings.
When stock prices move higher, it is typically the result of one of two factors, or both working in concert: either company earnings are increasing, which allows the share price to increase while maintaining the same P/E ratio, or investors decide they are willing to pay more for a given stream of earnings, causing the share price and P/E ratio to climb. Both of these factors can occur at the same time. During the recovery from the great recession, earnings have improved, but much of the increase in share prices has been the result of investors willing to pay more for those earnings – P/E, or multiple expansion, as it's called.
Overall, this metric is a valuable and succinct way to describe a company or group of companies' relative value. However, there are some idiosyncrasies involved with P/E ratios that investors should be aware of. We'll begin with a basic recap of this metric, followed by some commentary on its "curious nature."
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The P/E ratio is simply the ratio of a company's share price to it's reported (or anticipated) earnings per share. It's calculated as follows:
When looking at P/E ratios, one must be observant as to whether the EPS component is being calculated based on historical earnings, or from anticipated earnings (aka Forward P/E). Both have value, but it's good to remember that analyst projections nearly always err on the side of optimism. Also, when looking at historical earnings, it's important to determine whether earnings are based on the prior full year (often referred to as TTM or Trailing Twelve Months) or are just being extrapolated from the most recently reported quarterly EPS. Using TTM is much more common.
Yet another iteration to be aware of is the use of a cyclically adjusted P/E ratio. This usually goes by one of these names: CAPE – Cyclically Adjusted P/E, Shiller P/E, or P/E 10 (the 10 referring to how many years of earnings data were used in the denominator). This helps to smooth out fluctuations in the P/E which can cause large aberrations, as we'll see below.
Now for the idiosyncrasies of this broadly used metric.
Let's start with the basics. The chart below is from multpl.com and shows the historical S&P 500 P/E based on Trailing Twelve Months (TTM) earnings. Immediately, we can see that the market P/E ratio fluctuates dramatically over time.
The most recent spike in the chart, which goes off the page, occurred in early to mid 2009, near the bottom of the bear market. As noted in the table below, the P/E ratio during this time rose to over 100, topping out near 123. A basic interpretation of P/E ratios would have considered the market extremely overvalued at this time, but was it? Turns out this period was one of the best buying opportunities in decades.
So why the discrepancy and why the spike in the P/E ratio? It all has to do with earnings. In early to mid 2009, the stock market had plummeted with the S&P losing roughly half its value. The interesting thing is that while share prices had fallen in half, earnings had actually fallen much further. The dramatic decline in earnings outpaced the decline in share prices, causing the P/E ratio to spike. Those who saw through the subtleties of the P/E ratio still entered the market, while acknowledging they were paying over 100 times last year's earnings. It turned out to be a great move.
The takeaway from this example is that P/E ratios don't behave properly during periods of economic unrest, when earnings are declining. As earnings approach zero, a P/E ratio will approach infinity. What happens when earnings go negative? Well in that case we don't really have a P/E ratio anymore. Mathematically we'd have a negative P/E ratio, which would indicate investors are paying to lose money... We actually did have one case in which this occurred. In Q4 of 2008, S&P earnings came in at -.25. This was the only quarter in the history of the S&P 500 to post negative earnings.
The massive volatility in P/E ratios based on TTM data has led many to use a variation of the P/E known, as previously noted, as either CAPE, the Shiller P/E, or P/E 10. They all refer to the same calculation, which involves dividing the current share price by not one, but ten years’ worth of earnings, adjusted for inflation. As you can imagine this smooths out fluctuations in the denominator, allowing for a less volatile metric. The Shiller PE is shown below.
Some final thoughts:
1. Beware which P/E ratio you are looking at, as each version can provide a drastically different figure, as well as a different sense of what P/E is "normal" in terms of historical market valuation.
2. Don't always assume that a low P/E means a company is cheap or undervalued. Remember that the markets are smarter than any of us. If the market has attributed a low P/E ratio to a company or group of companies, there may be a very good reason for it.
3. P/E ratios are lagging indicators when they are based on past earnings. Any new information that can materially affect earnings is likely to be immediately reflected in the share price, but not in the EPS. This can lead to distorted P/E ratios until reported earnings accurately reflect the new information. This is the type of scenario where looking at a P/E based on anticipated earnings can be beneficial, as the anticipated earnings should immediately reflect the new information.
4. The amount of leverage a company employs and how a company uses its revenue can have a large effect on P/E ratios. Consider the peculiar case of a company like Amazon. Amazon invests most of its revenue back into the company. This leaves little in the way of earnings, yet investors know that Amazon has the potential to produce dramatic earnings if and when reinvestment in the company is curtailed. This distorts earnings, and thus the P/E ratio, which is currently over 600. Many growth companies fall into this category. P/E ratios (at a company level) are better suited for valuing mature companies than explosive growth companies.
5. EPS is based on accounting measures of earnings that are subject to various forms of manipulation. The quality of a P/E ratio is only as good as the quality of the reported earnings.
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The above content was an excerpt of Richard Russell's Dow Theory Letters. To receive their daily updates and research, click here to subscribe.
