The value of Price/Earnings Ratio
If you consider investing in stocks to not be too dissimilar to investing in property, we can do some analogies
Growth vs Income stocks
Stocks tend to be categorised as either:
- Growth stocks - these are companies which are typically early in their lifecycle and need to keep on growing to ward off competitors and/or still believe that they can substantially increase revenues and profits. These companies will tend to re-invest a substantial proportion of their profits back into the company
An analogy with the property market might be if you had a London house in the late 1990s up until 2016 where there was a population boom in the city with wealthy buyers and tenants flocking in from Europe and elsewhere. In this situation, developing your house would result in a better market value
- Income stocks - companies after a while tend to have exhausted new avenues for revenue/profit growth so see less value in investing within the company. In this situation, investors are looking for income in terms of a share of the profits (paid out as dividends)
A comparison in the property market might be buying a house in Middlesborough. There is less of a population movement so less opportunity for the house price to increase. However, as a Landlord you might to choose to rent out property there because it's relatively cheap to buy property and the rent yield is substantially higher than you would get relative to the house price than you could obtain in London.
So when you're evaluating a stock, 1 of the key metrics to consider is the price-earnings ratio and how it compares to it's sector. As with the house analogies, you can either pay for an expensive stock with low/no dividend (high p/e ratio) with the expectation that the price will keep going higher, or you can go for cheap stocks with high dividends (low p/e ratio) or anywhere inbetween.
Tech companies, as an example, tend to be high growth and hence attract high P/E ratios, whereas the energy industry is seen as low growth but high dividend paying and hence have low P/E.
Which you choose is really up to you. But what you don't want to end up with is an expensive purchase that has no growth in it's price and doesn't pay a dividend.
Trailing vs Forward P/E ratios
Another thing to bear in mind when looking at published P/E ratios is the difference between trailing P/E and forward P/E. A trailing P/E ratio is determined by dividing the market capitalisation by the published earnings per share. So that's looking backwards. However with fast growth companies, forward P/E divides market cap by analysts view as to where earnings per share is heading. As markets supposedly value companies on their prospects rather than their past then this is arguably the more important parameter.
Cyclically Adjusted P/E Ratio (CAPE)
Another argument that is made when evaluating P/E ratio is that it can vary substantially throughout the business cycle so isn't the best measure for evaluating a company. For example in a recession, company earnings might be 20% of where they were during better times which would mean that the P/E ratio would shoot up by 5 times making the company look very expensive and not investible, and the stock price would drop dramatically. However, the recession might only last a year or two, and suddenly earnings are back up to where they should be and the stock price would shoot up again.
So an alternative measure to look at which take into account the full business cycle is the Cyclically Adjusted Price Earnings Ratio (CAPE), also known as the Shiller P/E or P/E 10 ratio, which is a valuation measure usually applied to the US S&P 500 equity market. It was popularized by Yale University professor Robert Shiller. The CAPE ratio uses real earnings per share (EPS) over a 10-year period to smooth out fluctuations in corporate profits that occur over different periods of a business cycle. It is defined as price divided by the average of ten years of earnings (moving average), adjusted for inflation. This ratio is used to assess whether the market is undervalued or overvalued. While the CAPE ratio is a popular and widely-followed measure, several leading industry practitioners have called into question its utility as a predictor of future stock market returns as it's calculated by looking backwards over last 10 year's worth of earnings which might not work so well with fast growth companies.
P/E Growth (PEG)
The Price/Earnings-to-Growth (PEG) Ratio is a valuation measure that investors and analysts use to assess a company’s performance and evaluate investment risk. The PEG ratio is calculated as a stock’s price-to-earnings (P/E) ratio divided by the growth rate of its earnings for a specified time period. This ratio is used to determine a stock’s value while also factoring in the company’s expected earnings growth, providing a more complete picture than the P/E ratio. A PEG ratio of under 1.0 can indicate a stock is undervalued, while a PEG above 1.0 can indicate an overvalued stock. However, the accuracy of the PEG ratio depends on the inputs used, and it’s important to find out which growth rate was used in the calculation.
