The price/earnings ratio is the most popular valuation metric, cited often by
professionals and amateurs alike. Earnings, or profits, represent what a
company has earned after it pays its bills. Valuing a company relative to its
profits makes sense. After all, don’t you want to generate the maximum
profit for every dollar you invest? When you purchase a share of stock, you
acquire a tiny piece of a company’s earnings. And what the market will pay
for those earnings tells you a lot about the company.
To calculate the price/earnings (P/E) ratio of a particular stock, you’ll
need the stock’s share price and its earnings over the last four quarters—
often called 12-month trailing earnings. Companies report earnings four
times a year, with most—including Pfizer—breaking the year down into the
three-month periods ending March, June, September, and December. (Some
companies report in January, April, July, and October, or February, May,
August, and November.)
Visit your preferred financial website, type in the ticker symbol for the
stock you wish to analyze, and seek out historical earnings data on the page
containing information on earnings estimates. Most pages with estimates
will list earnings for the four most recent quarters. Simply sum the earnings
per share for those four quarters, and you have trailing 12-month earnings
per share. For example, Pfizer traded at $28.21 per share at the end of
August 2013, and earned a total of $2.10 per share in the last four quarters,
or the 12 months that ended in June. Divide the share price by per-share
profits, and you get a P/E ratio of 13.4.
After you calculate the P/E ratio, do the same for other companies in the
same industry. You can’t just pick other companies randomly, because P/E
ratios vary from industry to industry. For example, oil refiners have traded
at low P/E ratios for decades. Software companies, on the other hand, tend
to command higher P/E ratios than the average stock. If you compare a
software company to a refiner, the refiner will almost certainly look cheaper
—even if that refiner trades at a far higher P/E ratio than its peers.
However, that refiner may not actually represent a better value.
Suppose you select a refiner that trades well above the typical valuation
for its industry, and you select a software company that’s among the
cheapest in its group. Even with a higher absolute P/E ratio, the software
company might represent a superior value. Before you make that
determination, perform a peer-group valuation comparison and also review
the stocks’ growth, profitability, and other factors.
In Pfizer’s case, comparable stocks include Merck, Eli Lilly, and BristolMyers Squibb. Be careful when selecting competitors for comparison. When
possible, you want companies that operate in the same markets as your
target and which also compete in the same weight class. In other words, if
you want to analyze Pfizer relative to other drug companies, select the
biggest ones you can find. As the table illustrates, Pfizer trades roughly in
line with two of its largest peers—based on P/E—but looks much cheaper
than Bristol-Myers Squibb.
While the traditional P/E looks backward, you can also use the ratio to
look forward. P/E ratios that use estimates provide another view of the
company, one that hints at a story you won’t hear from valuation ratios
relying on historical numbers. Instead of dividing the share price by
earnings over the last 12 months, use the estimate for profits in the current
fiscal year or the next year. You can find these estimates at any of the
financial websites mentioned earlier.
For instance, Pfizer is expected to grow per-share profits 5% this year
and 4% next year. For the most part, analysts don’t expect much growth
from the big drugmakers. Not surprisingly, since earnings represent the
denominator of the P/E ratio, rising earnings will equate to a lower ratio. As
of August 2013, Pfizer traded at 12.8 times the profit estimate for 2013 and
12.2 times the 2014 estimate. Pfizer looks somewhat cheaper relative to its
peers based on the P/E ratio using the 2014 estimate than it did using
trailing profits.
While the P/E ratio effectively gauges value for most companies, it’s not
perfect. When you consider a company’s P/E ratio, keep the following
points in mind:
Earnings do represent the bottom line, but companies can manipulate
earnings by changing their accounting.
Companies that lose money have negative earnings, and valuation
ratios mean nothing if the denominator—in this case earnings—is
negative. P/E won’t work as a valuation tool for unprofitable firms.
As a rule, industries or companies with higher expected growth tend to
sport higher P/E ratios, as the market will pay extra for higher profits
in the future.
When you see a company with an abnormally low P/E, dig a little
deeper. The P/E ratio, like all valuation ratios, reflects the company’s
perceived risk. Suppose a company faces increased competition or new
government regulation that could slow its growth. In cases like these, it
might deserve a lower P/E. In other words, while some low P/Es
indicate bargains, others have become cheap for good reason.
Price/Earnings Ratio.
