PE ratio probably is one of the most wildly used ratios for investors to make the investment decision. The reason might be because it is easy to understand and it simplifies the decision making. However, it might be misleading by only looking at the PE ratio
What is PE Ratio?
PE ratio stands for price-to-earnings ratio. It is the current stock price divided by the annual net income (earnings) per share (EPS). For example, if stock XYZ is trading at $20 and its annual earnings per share is $2, the PE ratio would be $20/$2 = 10
Implication of PE Ratio
PE Ratio is usually used to
compare to the yield of other investment alternatives. From investors’ point of view, when they buy a stock with PE ratio 10, it can be treated that this investment has annual return on investment 10% (you paid $20 for a stock that can earn $2 in a year). With that mindset, you can compare to other investment alternatives to determine the relative attractiveness. (Remember the article
Market Risk Premium 101?)
You can also
compare the stock’s current PE ratio to its historical PE ratio to get a sense whether the stock is relatively cheap at this point of time. For example, if stock XYZ was trading at PE 100 last year but is currently trading at PE 10, it seems this stock is relatively cheap at this point of time
Can’t Make Investment Decision by PE Alone
However, there are traps here by making investment decision purely using PE ratio:
1.
Stock price fluctuates all the time: Even though we say that PE ratio 10 can be treated the same as 10% annual yield, there is no guarantee the stock price won’t go down. It is possible that stock XYZ is trading at $20 now with PE ratio 10 but goes down to $10 after one year. Besides that, depends on the company policy, you don’t really benefit immediately from $2 earnings if the company doesn’t pay any dividend
2.
Earnings fluctuate year over year: Even though a stock might seem to be expensive at this point of time, that doesn’t automatically make it a poor buy. The trap here is that earnings will change year over year. For example: if stock XYZ has average PE ratio 10 historically and is currently trading at $20 with past 12 month earnings $1, its PE ratio is 20. It seems to be expensive now. Suppose this company is doing very well for the next year so that after one year, its past 12 month earnings increased to $2.5. If stock price is still trading $20, its PE ratio changes to 8. If we have crystal ball to tell us the company XYZ is going to have earnings $2.5 for the next year, that will make this stock’s current trading price ($20) a good buy. Unfortunately, no one has crystal ball.
Important of the Expectation of Earnings Growth Rate
From the above example, not only PE ratio but also the expectation of the future earnings growth rate will affect the stock price. If investors believe that the company XYZ is going to have high earnings growth rate, they might be willing to pay higher price to own its stock even that means buy at high PE ratio. On the other hand, if investors believe that the company XYZ is going to have slow or negative earnings growth rate, PE ratio of that company’s stock tends to be low. As you can see, because no one has crystal ball, it is the “expectation”, not the “real”, future earnings growth rate that drive the stock price up and down.
Introduction to PEG Ratio
PEG ratio of a particular stock is its PE ratio divided by its expected annual EPS growth rate, as a percentage. The rationale behind this calculation is that if stock is trading at high PE, it is expected to have high EPS growth rate, and vice versa. For example: if stock XYZ currently is trading at PE ratio 10 and its expected EPS growth rate is 10%, the PEG ratio of stock XYZ is 10/10 = 1. Because PEG ratio take stock’s annual EPS growth rate into consideration, many investors use PEG ratio to determine if a stock is under or overvalued. The lower the PEG ratio, the better (more undervalued) the stock is (same PE with high EPS growth rate or same EPS growth rate with low PE).
In Practice
We can use
Stock Fundamental Data Download to see the current PEG ratio distribution of companies listed in Down Jones. The PEG ratio number is extracted from Yahoo Finance. It is based on the expectation of the next 5 years growth rate. Following is the result sorted by PEG Ratio.
As of today (02/16/2012) GM has the lowest PEG ratio (0.41) while T has the highest PEG ratio (3.39) among Down Jones stocks. If you pay attention to the
dividend yield, you see that in general companies have low PEG ratio pays little dividends compared to companies have high PEG ratio. It is obvious that there is always a tradeoff in terms of investment. The final decisions really depend on your ultimate goal, which could be different among individuals.
Let us emphasize one more time, No matter what the data source is, the annual EPS growth rate you see is the “expected” number because no one can foresee what will happen in the future. That’s the reason why you will see the dramatic price movement of some stocks after the earning is announced.
