There are all sorts of ratios and metrics that investors can use to determine whether a stock is undervalued relative to the investment returns it is expected to produce.
The most commonly-used one by far is the price-to-earnings ratio, often referred to as the P/E ratio.
This article takes a look at the popular P/E ratio, how it’s calculated, what’s good about it, what’s wrong with it, and which other stock valuation methods are often better.
P/E Ratio: Applications and Shortcomings
The price-to-earnings ratio (P/E ratio) is the price of a share of stock divided by its earnings-per-share.
The earnings-per-share of a company is the total net income of the company divided by the number of shares of the company that exist. For example, if a company makes $2 billion in net income per year, and the company consists of 500 million shares, then the earnings-per-share is $4.
If shares of a company are currently trading for $60, and its earnings-per-share this year equals $4, then its P/E ratio is 60 divided by 4, which equals 15.
All else being equal, it’s better to buy stocks with low P/E ratios, because you are getting more earnings for your investment.
However, the P/E ratio can be very misleading. Look, for example, at the average P/E ratio for the S&P 500 over time:
Chart Source: multpl.com
The stock market crashed in 2009 during a severe recession, and stocks were quite cheap and provided great returns over the next decade. However, the P/E of the market was actually off the charts high, because earnings were so low. Investors that focused on the P/E ratio missed out on buying great stocks at low prices according to most other valuation metrics.
The inverse problem happens during market peaks. When stocks are high-priced at the top of the economic cycle, their P/E ratios often aren’t very high. That’s because their peak earnings that year are also very high. When an economy has full employment, years of positive corporate growth in a row, record profit margins, and all sorts of positive aspects, investors should be skeptical whether this high level of earnings is sustainable or not.
Another problem is that many low P/E ratio stocks have low P/E ratios for a reason. There’s often something broken with the company, like it exists in a dying industry, has too much debt, or is losing market share to competitors. As you’ll see below, it’s important to factor in other metrics as part of a stock valuation process.
Forward P/E Ratio
Some analysts use the “forward P/E ratio”, which means using next year’s estimated earnings as your denominator rather than the actual trailing earnings over the past 12 months.
This is fine, as long as its a fair comparison. I sometimes use forward P/E ratios in my analysis. For most healthy companies, their next year’s earnings are expected to be higher than the current year’s earnings, meaning their forward P/E is lower than their current or trailing P/E ratio.
Many analysts on television seem to use whichever valuation metrics justify their bullishness. In other words, if stocks appear expensive by multiple metrics, many analysts seem to say, “it’s not that expensive; the price to next year’s earning is only 20.”
When things are great, the majority of investors are excited and cherry pick whichever metrics indicate that the stock market will keep getting better. When things are bad, the majority of investors are scared and cherry pick whichever metrics indicate that the stock market will keep getting worse. It’s human nature.
The forward P/E ratio has the same problems as the P/E ratio. It uses earnings as a one time snapshot, which can be misleadingly high or low in certain parts of the business cycle. Additionally, the forward P/E relies on estimates of next year’s earnings, which has obvious room for error.
Fair P/E Ratios for Various Stocks
Many investors target a 10% long-term rate of return or higher from their stock holdings.
One way to think about the P/E ratio is to flip it around and calculate it as the earnings yield. In other words, the E/P ratio, earnings-per-share divided by share price. If a share of stock currently trades for $20, and has earnings-per-share of $2, then its E/P ratio is 2/20 which is equal to 0.1 or 10%. This will be relevant for examples in this section.
Zero Growth Stock: 10 P/E Ratio
As a thought experiment, imagine what your return would be if a company were to just pay all of its earnings to its shareholders as dividends.
A stock with a P/E ratio of 10 (or an earnings yield of 10%), that doesn’t grow at all, can pay out a 10% yield to shareholders every year if it wanted. More realistically, they could pay a part of that as dividends, and use a part of that for share buybacks to boost earnings per share each year. The combination of share buybacks and dividends is called the “shareholder yield”, which is a measure of what percentage of the stock price that the company is returning to shareholders per year.
In other words, a stock with a P/E of 10 can theoretically give a sustainable annual rate of return of 10% with zero growth, if investors receive a 10% earnings yield as dividends or buybacks and reinvest it back into the stock. If you target 10% annual returns, it’s fair to pay a P/E ratio of about 10 for zero-growth company.
That’s a bad sign though, because a zero-growth company isn’t even keeping pace with inflation and population growth, meaning it’s likely in trouble for one reason or another.
Slow Growth Stock: 12 P/E Ratio
Then, suppose there is another company that doesn’t really grow its number of customers or anything, but at least it keeps its pricing up with inflation. In other words, if inflation is 2% per year, this is a company that is growing its revenue and earnings by about 2% per year.
If you pay a P/E ratio of 12 for that stock, then its earnings yield will be 8.3%, meaning it could pay up to a 8.3% dividend each year if it used all of its earnings, or more realistically a 8.3% shareholder yield consisting of a combination of dividends and buybacks. It could also grow earnings and dividends by 2% per year, for about a 10.3% total annual rate of return.
Thus, it’s fair to pay a P/E ratio of about 12 for a very slow growth stock that just keeps revenue growth on pace with inflation.
Moderate Growth Stock: 15 P/E Ratio
Now, imagine a company that grows in line with GDP. In other words, it doesn’t grow market share, but it grows in line with the combination of inflation, population, and productivity increases over time. For a developed country, that’s 3-4% per year. Additionally, it doesn’t have to reinvest its earnings to generate this moderate growth; all of its earnings are free cash flow.
If you pay a P/E ratio of 15 for that type of stock, its earnings yield would be 6.6%, meaning it could theoretically use all of its earnings to pay a 6.6% dividend or shareholder yield. If it grows its earnings by 3-4% per year, that’s 9.6%-10.6% annual returns.
Thus, it’s fair to pay a P/E ratio of about 15 for a moderate-growth stock with healthy free cash flow that just keeps up with GDP growth (changes in inflation, productivity, population combined).
Fast Growth Stock: 25 P/E Ratio
Companies cannot grow faster than GDP forever, because if this continues infinitely, they would grow larger than the whole economy (which can’t happen, since they are a part of the economy).
However, many powerhouse growth companies can grow at a much faster rate than GDP for decades, because they exist in a growing industry that displaces other industries, or they take market share from competitors. Eventually, they become so big that they slow down.
Imagine a company that is expected to grow its revenue and earnings by 10% per year for the next decade, and after that will slow down to 3-4% perpetually as a moderate growth stock. And like the previous examples, it doesn’t need to reinvest its earnings to achieve this growth; its earnings are equivalent to free cash flow.
Using StockDelver, I calculate that a fair P/E ratio would be 25 for now. In ten years when it is growing at 3-4% per year, its fair P/E ratio would be down to about 15 like the previous example from that point on.
Very Fast Growth Stock: 40+ P/E Ratio
Lastly, imagine a company that is expected to grow its revenue and earnings by 20% per year for the next decade, 10% for the decade after that, and 3-4% forever after that. This is like one of the big tech titan stocks that could go on to become a trillion-dollar company.
Again using StockDelver, I calculate that a fair P/E ratio would be about 75 for now. In a decade, its fair P/E ratio would be 25 (although its earnings will be huge by then), and a decade after that its fair P/E ratio would be down to 15 like a regular stock.
However, paying a 75 P/E ratio for a stock is very risky, because if it grows even a little slower than expected over the next decade at only 15% annually, then its fair P/E would be 50.
Normally, investors that buy this type of fast-growing stock expect to achieve higher rates of return of 15% or more per year in exchange for taking on this type of risk.
If an investor desires a 15% annual rate of return, and a company is expected to grow by 20% annually for the next decade, 10% annually for the decade after that, and 3-4% annually after that, then a fair P/E ratio would be about 50. For a margin of safety, you should try to aim closer to about 40.
|Company Annual Growth Rate
|Fair P/E Ratio
It’s always good to have a margin of safety when investing, so that even if a company grows a little bit slower than expected, you’ll still reach your desired rate of return. Alternatively, if it grows just as good as expected, you’ll probably exceed your rate of return.
Thus, if you consider a company’s fair price-to-earnings ratio to be about 15, try to get it for less.
For this reason, company debt should be a consideration. If two companies are growing at the same rate, but one has zero debt and the other is highly leveraged with debt, then the high debt company is riskier, and should have a discount to its otherwise fair P/E ratio.
Basically, in any efficient market, if there are two companies with identical expected growth rates but one has a great balance sheet while the other does not, the one with the great balance sheet should have a higher P/E ratio.
4 Stock Valuation Methods Better than the P/E Ratio
The gold standard for valuing stocks or anything that produces cash flow is discounted cash flow analysis.
Pretty much everything else is a shortcut of that method, but that’s okay. Shortcuts that make sense are great. Here are some valuation methods that are better than just the simplistic P/E ratio.
Price to Free Cash Flow Ratio
Free cash flow is generally a more truthful accounting item than net income.
Net income can be “managed” with various accounting tactics to make it look smooth and normalized over time. However, free cash flow is a more raw figure of how much cash the company is bringing in after paying for its various capital expenditures.
Therefore, when analyzing a stock, it’s always worth checking its price to free cash flow ratio, or P/FCF.
Sometimes, a company seems to have a high P/E ratio compared to its growth rate, but it generates far more free cash flow than net income. Thus, it may actually be appropriately valued or even undervalued.
Alternatively, sometimes a company seems to have a low P/E ratio despite solid growth and looks like a great investment, but when you dig deeper you see that it generates very little free cash flow, or maybe even negative free cash flow. Its earnings are more questionable, more “managed” with accounting tactics, and it could be a much worse investment than the P/E ratio would imply.
Real estate and infrastructure companies often generate a lot more free cash flow than net income due to accounting depreciation. For that reason, companies in those industries often use metrics that are similar to free cash flow, like “distributable cash flow” or “funds from operations” or “adjusted funds from operations”.
Whenever you evaluate a REIT or a midstream company, it’s best to focus those metrics that focus more heavily on cash rather than the P/E ratio which will often look too high.
As we saw in the earlier examples involving growth rates, P/E ratio of a company tells you very little by itself. You also need to know its growth rate, among other things.
For example, if a stock has a P/E ratio of 10 but is stagnating or shrinking, that might not be a very good investment. On the other hand, a stock that is growing tremendously but has a P/E ratio of 40 might still be an exceptional investment. Clearly, we need to factor in growth.
The famous mutual fund manager Peter Lynch popularized the “PEG ratio” as one of his key stock valuation methods.
The PEG ratio is the P/E ratio divided by the expected earnings growth rate. Lynch liked buying companies trading below a PEG ratio of 1. Using that tactic among others, he generated 29% annualized returns for more than a decade, but that was in a time of lower stock valuations in general.
For example, if a stock is trading for $24/share and has earnings-per-share of $2, then it has a P/E ratio of 12. If its earnings next year are expected to be $2.24, and $2.51 the year after that, then the earnings are growing at 12% per year. The P/E of 12 divided by the growth rate of 12 is 1. The stock therefore has a PEG ratio of 1.
If its growth is only 6% per year, then its PEG ratio is 12/6 = 2. If its growth rate is 8% per year, then its PEG ratio is 12/8 = 1.5.
You can further improve this with the dividend-adjusted PEG ratio. Stocks that pay dividends usually grow at slower rates, but their dividend makes up for that. The standard PEG ratio doesn’t factor in dividends though.
The dividend-adjusted PEG ratio adds the current dividend yield to the growth rate. In other words, if a company is growing earnings at 8% per year and pays a 3% dividend yield, then you plug 11% into the PEG equation as the growth rate.
For example, consider a stock with a P/E ratio of 16. It is growing at 8% per year and pays a 4% dividend. The PEG ratio would be 16/8, which is 2. However, the dividend-adjusted PEG ratio would be 16/12, which is 1.33, which makes it correctly look a lot more attractive.
There is a range of appropriate dividend-adjusted PEG ratios for companies, depending on how risky they are and what your realistic target rate of return is. As a general guideline, an investor would do well to be skeptical of buying stocks with a dividend-adjusted PEG ratio above 2.
Market Capitalization to GDP Ratio
A broad measure of overall stock market valuation popularized by Warren Buffett (and often called the “Buffett Indicator”) is the total stock market capitalization divided by the gross domestic product of a country.
It gives you a general idea of how expensive the stock market is compared to actual economic output, relative to where the ratio historically tends to be.
Here, for example, is a chart of the market capitalization of virtually all U.S. equities (blue line) compared to GDP (red line) since 1990:
In the United States, stock market capitalization as a percentage of GDP has gotten as high as 150% during peaks, and below 60% during severe recessions.
Investors need to take into account changing tax rates and the changing percentage of revenue that U.S. companies make from overseas, but overall it’s a useful ratio to be aware of when determining your asset allocation and how aggressive or defensive you might want to be with your portfolio in general.
Since the 1990’s, the S&P 500 has earned 40-45% of its revenue from outside of the country without much change, so it remains a relatively useful apples-to-apples comparison.
As a note, you can’t use this to compare valuations between countries. Each country has a very different percentage of revenue that their companies earn from overseas, or what percentage of their economy consists of publicly-traded companies vs private businesses. However, you can realistically use the ratio to compare a country to its recent historical self, like in the chart above.
Cyclically-Adjusted P/E Ratio
The cyclically-adjusted price to earnings ratio, better known as the CAPE ratio or Shiller P/E ratio, is a longer-term calculation for the P/E ratio of a stock or stock market.
Like the market capitalization to GDP ratio, the CAPE ratio is usually used for the purpose of broad market valuation, to get an idea of whether the market as a whole is cheap, expensive, or somewhere in the middle. It can also be applied to specific market sectors, like healthcare or technology, for example.
The normal price to earnings ratio just divides the share price by the earnings per share. The CAPE version, however, divides the current share price by the inflation-adjusted average of the past ten years worth of earnings.
That helps avoid situations where the P/E ratio looks very high during recessions, or low during peak earnings periods. It’s a more reliable indicator because it compares the current price to a longer-term sample of earnings over the course of a full typical business cycle.
Here’s a chart of the CAPE ratio over time:
This chart more closely captures actual market valuations. For example, the CAPE ratio of the S&P 500 was high during the 2000 Dotcom Bubble and was low during the bottom of the financial crisis in 2009.
There are no perfect valuation metrics, and each method has its downsides. An experienced investor must be able to figure out the right tool for the job, meaning the best method of valuation for a given investment or market, given its unique characteristics.
There are a lot of other valuation metrics available than the ones listed here, including the dividend discount model or the equity risk premium model, as two examples.
Discounted cash flow analysis is the closest thing an investor has to a universal valuation method for anything that produces cash flows, but even that requires some human assumptions and decisions for inputs. These various methods are all short-cut ratios or metrics that are worth being aware of for most investments, and many of them are easier to apply on a broad scale.
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