The Essential P/E

Understanding the stock market through the price-earnings ratio

Keith Anderson

• Publisher: Harriman House
• Year: 2012
• Print ISBN: 9780857190802
• eBook ISBN: 9780857192448
• Edition: 1
• Topic: Business
• Subtopic: Investments & Securities
• Index: Business

The price-earnings ratio, or P/E, is the most commonly quoted investment statistic, but have you ever considered what it actually means? For most people it's a shorthand way of deciding how highly the market regards a company, with investors prepared to overpay for earnings from a high-P/E 'glamour' stock as opposed to a low-P/E 'value' stock. However, academics have known since 1960 that the opposite is true: value stocks outperform glamour stocks consistently over decades.A company with a low P/E may have been marked down for no readily apparent reason and thus could represent an attractive value investment for those with the patience to wait while the market re-values it. However, the P/E is a backward-looking measure and just because the company earned £1 per share last year it doesn't necessarily mean it will earn anything like that in the foreseeable future. Or, a low P/E can mean a company is deservedly cheap because it is in financial difficulty - in this case the company is likely to become cheaper yet or even go into administration.This book is a practical guide to how you can adjust and improve the price-earnings ratio and use it, alongside other financial ratios, to run against the crowd and boost your stock returns.

PART I. The P/E Calculation

This Part starts with the story of how investors came to use the P/E. It has been in use for less than a century, but during that time it has become the most important investment ratio as far as practical investors are concerned.

A chapter looks at the more complicated component of the P/E: earnings. How the market decides share prices minute-by-minute is extremely complicated, but viewed from the level of the P/E calculation, the price used is quite straightforward. Earnings, however, are much more complex. There are many possible definitions of which parts of the profit and loss account are really ‘last year’s earnings’, and I cover them in detail here.

Having defined earnings, the share price and then the price–earnings ratio itself are covered in the following chapter. As with earnings, there are several different ways of calculating the P/E.

All the theory is brought to life in this Part’s final chapter, with a detailed example of how the P/E works in practice using Haynes Publishing’s annual report.

Chapter 1. History of the P/E

The P/E ratio is today the most commonly used valuation metric in the world.

Prof. Janette Rutterford, Open University, 2004

The P/E has a long history, but it has not always been the most popular way to value shares. Since the invention of stock markets up until less than 100 years ago, the dividend yield (DY) was the main figure every investor was interested in. The asset backing behind a company was also important. The P/E is, compared to these two, a relatively recent invention. Even the phrase ‘price–earnings ratio’ only became popular in the 1920s in the US. In the UK dividends were still what mattered up until the mid-1960s.

The world of investment to 1914: dividend yield is king

For centuries, at least since the time of the South Sea Bubble in 1720, dividend yield (DY) was the main ratio investors used to value their stocks. This is simply the ratio of the dividends paid out last year to the price of the stock. So if a stock costing £1 paid out 5p in dividends last year, the dividend yield of 5% compares favourably to the return available from a deposit account (in 2011), but of course involving the risk of capital loss should the share price fall.

In the US, bond issues during the 1800s and early 1900s outweighed stock issues three to one. The stock market consisted largely of railway stocks, with utilities and then industrials only becoming more important by 1900. In these circumstances it is hardly surprising that dividend yield was the favoured method of deciding whether a stock was cheap or expensive, because dividend yield could be directly compared to the yield on a bond.

In the UK, the stock market was more developed, even though the railway boom was equally active. One feature was how internationalised the stock market was: the majority of new issues was of foreign stocks and bonds. Another feature strange to a modern investor was the preponderance of debenture and preferred stocks. In a new issue from an established investment-grade company, these were often the only type of stock an investor could buy. The founders would keep control of the ordinary stock. It was speculative companies that issued ordinary shares.

Even in the UK though, DY was the main statistic that investors were interested in. This could have been due to the limited information published in what we now call an IPO (Initial Public Offering) (this term is itself only about twenty years old). The only information a purchaser of a new issue would likely get would be profits averaged over several years (to even out the ups and downs), money available to pay the ordinary dividend after paying the preferred shareholders, and the balance sheet. Given the limited information made public in those days, it is not surprising that a more sophisticated analysis of company earnings was not yet possible.

The US in the 1920s: enter the P/E

DY in the US maintained its hold until the mid-1920s. The P/E only really became popular during the boom years of the late 1920s. Earnings themselves had boomed since the Great War. People were more interested in earnings growing at 10% or 25% annually than dividends growing at 5%. Everyone believed that this long-term growth could be kept up indefinitely due to rapid technological change. US company accounts were also generally more informative than in the UK, so that investors in US companies could see what was happening to retained earnings. They could appreciate the fact that the effect of compound interest on a company’s growing reserves would mean higher dividends and hence higher share prices in the future. Ben Graham and David Dodd could already comment in their 1934 classic Security Analysis:

Common stocks have come to depend exclusively on the earnings exhibit.

Catching up with the US

Meanwhile, DY remained for decades the main valuation ratio in the UK. Earnings were overwhelmingly paid out as dividends, whereas in the US a significant proportion was held back as undistributed profits. UK corporate earnings had themselves not shown the long-term rapid growth that US companies had experienced, so the gap between the two valuation methods was not as marked.

Relatively uninformative UK company accounts did not help: consolidated accounts (reporting the group’s overall position rather than individual companies within the group) were not compulsory until 1948, and even something as basic as turnover did not legally have to be disclosed until 1976. As a result you could find analysts in the same research note covering US stocks in an industry by looking mainly at their P/E, but the UK stocks in the same industry by mainly considering their DY.

It was not until 1965 that UK investors really caught up with the US in their use of valuation ratios. The introduction of corporation tax in that year meant that companies and individual shareholders were finally treated as separate taxable entities. Until then, companies had paid income tax on behalf of their investors, who might have to pay further tax depending on their level of income. Thus it was difficult to estimate company income after company taxes but before personal taxes. By 1966 The Economist was already valuing many UK companies using their P/Es.

The P/E today

Amongst practical investors the P/E has maintained its popularity since then. However, there are two areas in which the P/E has been eclipsed in recent years. Interest in it from finance academics has been limited since Eugene Fama and Ken French decided in the early 1990s that price-to-book value was a better indicator of value stocks and dropped the P/E from their now widely popular three factor model. (See later chapter.)

The other time the P/E has become little used has been during stock market bubbles. This is ironic considering that the P/E itself only came to prominence during the 1920s’ boom in the US. Some extraordinary P/E ratios occurred during the dot.com mania: America Online reached a P/E of 275 and Yahoo a P/E of 1900.

Extraordinary P/Es in the hundreds or thousands are telling investors that they are building castles in the sky, but during bubbles that is precisely the message that investors don’t want to hear.

Chapter 2. Earnings

Before we can cover the P/E itself, we should first define its more complicated component: earnings. This chapter covers the basics of the different ways in which earnings and then earnings per share (EPS) can be defined. I move downwards through the profit and loss account and discuss the different figures as more and more costs are deducted from profits. The discussion is purposely kept general here; for a practical example, see the later chapter on Haynes. I do not intend to give a detailed explanation of company accounts, as many other books do this; I cover only the components of the earnings calculation.

From sales to operating profit

The basics need little explanation.

A company produces goods or services and sells them; the amount the company receives here is termed the sales (or turnover, or revenue). From this figure of sales we need first of all to deduct the cost of the items sold to calculate the gross profit.

However, we have not yet reached the first figure that counts as earnings, because many expenses must be taken into account on top of raw materials, such as staff costs, IT, rent and so on. Other notional expenses, such as depreciation and amortisation, are also deducted. These are not necessarily items that have caused us to actually spend any cash this year, but they need to be deducted regularly from gross profit in any case. Declared profits would be excessively variable if large occasional expenditures on capital items were recorded as they happened. There is anyway a separate Consolidated Cash Flow statement.

‘Earnings’ as a word on its own is in fact a rather ill-defined catch-all term for any of the profit figures we now cover. The initial figure for earnings is the difference between revenue and the total of these costs – basically all the costs of the company excluding finance charges and tax. This initial earnings figure is called operating profit.

Towards the P/E’s earnings figure

Operating profit is the highest figure up the profit and loss account that is referred to as ‘earnings’. However, there are two unavoidable costs of running a business that still remain to be taken out: interest paid to service loans, and tax. Subtracting interest paid gives profit before tax. Finally subtracting tax paid gives profit from continuing operations. (De...

Table of contents

• Cover
• Publishing details
• About the Author
• Foreword
• Preface
• Introduction
• PART I. The P/E Calculation
• PART II. The Value Premium and the P/E
• PART III. Improving the P/E
• PART IV. Beyond the P/E
• Conclusion
• Appendix: FTSE 100 EPSs and P/Es
• Glossary
• References