First, what is P/E Ratio? “The price-earnings ratio (P/E ratio) is the ratio for valuing a company that measures its current share price relative to its per-share earnings.” (Definitions courtesy Investopedia.)
This seems a fine enough definition, but let’s dive into the real nitty gritty.
To calculate the P/E ratio, first one must calculate the Earnings Per Share (my emphasis added in some of the following quotes).
“EPS is most often derived from the last four quarters. This form of the price-earnings ratio is called trailing P/E, which may be calculated by subtracting a company’s share value at the beginning of the 12-month period from its value at the period’s end, adjusting for stock splits if there have been any. “
So the price used for the trailing P/E is the difference between the market price at the beginning of the 12 months from the market price at the end of the 12 months.
These two dates are used. These two dates may have little or no relation to the actual prices throughout the other trading days of the year. Or the general trend of prices and overall financial health of the company.
Then there is the forward P/E. This is usually calculated in one of two ways. It can be the difference between the market price two quarters back and the estimated market price two quarters hence. Or it can be the difference between the current market price and the estimated market price one year from now. The point is, it is an estimate, and who is ever estimating can estimate whatever they feel is appropriate.
The earnings part of the equation is the summation of net income of the company. This income is divided by the number of shares outstanding. Generally the number of shares used to calculate the per share part of the equation is adjusted for stock splits, share buy-backs, etc.
The earnings used can also be problematic: “While the market determines the value of shares and, as such, that information is available from a wide variety of reliable sources, this is less so for earnings, which are often reported by companies themselves and thus are more easily manipulated.” (Emphasis added.)
So we have many moving parts here. Earnings that may or may not be believable. Share prices that may or may not be representative of an overall reality.
In addition, as we have seen in a recent post, even widely known and respected sources of financial information can widely diverge about the same piece of information.
To sum up:
1. The price part of the ratio is the difference between prices on two dates, twelve months apart.
2. The earnings per share part of the ratio made of two parts:
A. One part is the number of share outstanding. (One can assume, I hope, that this is not subject to opinion.)
B. The second part is the net income (“earnings”) is usually calculated quarterly.
It’s like trying to pick a straight line between three planets, two of which orbit each other, and the third one is out there, somewhere. It’s possible, but everything is constantly in motion, and with a constantly changing length. So what was valid for one moment in time is no longer valid, because it has changed, and must be recalculated every moment, over and over. Is it worth trusting P/E?
It get more problematic when you realize that there are other measurements built on the P/E Ratio. So start with the P/E Ratio and include other factors. For example, the PEG Ratio is The P/E Ratio divided by the growth rate percentage of the company’s earnings.
And knowing a current P/E is not likely helpful without context.
So, while P/E Ratio is a commonly used measure, it is a rough measure. Very rough. Very very rough. I suspect there should be better numbers to use.
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