This article is part of Morningstar.co.uk's Equity Investing Week.
Question:
I know there are different ways to compute the price/earnings (P/E) ratio. How does this work and what method does Morningstar use?
Answer:
The P/E ratio is a popular metric used to assess a stock's valuation. A low P/E is often taken as a sign that the market is discounting the value of the stock's future earnings while a high P/E means its future earnings are selling at a premium. For example, a stock with a P/E ratio of 8 might be considered much cheaper--that is, a better bargain--than one with a P/E ratio of 25.
The P/E ratio is particularly useful when comparing stocks in the same industry. For example, fast-growing tech companies often have higher P/E ratios whereas utilities, which typically have fewer growth prospects, often have lower P/Es. If a stock's P/E is much lower than that of a competitor it suggests the market is less confident of the company's prospects. (Note: For certain industries, such as real estate, P/E is not always the best tool for deciding whether a stock is fairly valued.)
Calculating P/E
The basic P/E formula is a simple one: Take the stock's current price and divide it by its earnings per share over a given time period (usually 12 months) and you're there. So a stock selling at $10 per share with earnings per share of $2 has a P/E of 5. The complication lies in determining what to use for the earnings portion of the calculation and in particular whether to use earnings numbers that are backward-looking or forward-looking.
Backward-Looking P/E
Pro: Uses actual earnings data from the past 12 months as opposed to potentially unreliable analyst projections for earnings.
Con: Does not anticipate factors that could affect future earnings, such as a new product launch or industry changes.
Forward-Looking P/E
Pro: May provide a more useful picture of future earnings performance that is of greater relevance to investors who are considering buying, selling, or holding a stock.
Con: Forecasts may be inaccurate because of unforeseeable events or human error.
Finding P/E Information on Morningstar.co.uk
Morningstar.co.uk provides both backward-looking and forward-looking P/E ratios.
Morningstar.co.uk readers can find the backward-looking P/E ratio by visiting the stock's main overview page. This P/E ratio is near the top of the page, just above the stock graph.
This backward-looking P/E number is calculated by dividing the current stock price by the company's full-year earnings per share, which is derived from the company's most recent annual report.
Next, if you click on the 'Key Ratios' tab near the top of the stock information page, you will find forward-looking P/E information at the top of this page. The first P/E ratio is for the company based on brokers' forward-looking forecasts for earnings over the coming 12 months. (Sometimes Morningstar has a large sample of broker forecasts, but sometimes the sample is smaller.)
You can compare this forward-looking individual P/E ratio to the average P/E ratio for the sector and the average P/E ratio for the entire FTSE All-Share index. This helps investors understand a company's value versus its peers.
Key Tool for Value Strategy
P/E is often used by value investors to identify stocks that might be selling for less than they are worth. By screening on P/E ratio and other valuation metrics, value investors--and value fund managers--can come up with a list of companies that align with their strategy: buying undervalued stocks and holding them until their prices rise.
Although P/E can be a useful tool in evaluating the prices of stocks, the metric doesn't tell the whole story. P/E ratios indicate what could happen to the price of an individual stock based on a set of assumptions. That can be helpful, but it's far from a guarantee.
Other factors beyond P/E also need to be considered. For example, when assessing a stock, you should look at company management and the outlook for the company, its industry, and the economy.
The original version of this article was published on Morningstar.com.
