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Company Earnings

The PE Ratio and its Limitations

picture pe ratio 1

In principle the PE ratio is a simple concept - the companies stock price divided by its earnings per share. The PE ratio is usually the first piece of fundamental information that the new investor learns about. This is certainly helped by the financial press which loves to mention the PE ratio.

There tends to be two interpretations investors make about the PE ratio.

Interpretations investors make about the PE ratio:

  1. A low PE ratio means that the stock is cheap which makes it a value stock and a high PE ratio means that the stock is overpriced.
  2. A low PE ratio means that the stock has little growth potential if any and a high PE ratio means that it's a growth stock.

Notice that the two interpretations lead to opposing conclusions.

The first interpretation implies that a low PE ratio is desirable as the investor can purchase stock at cheap prices.

The second interpretation implies that a high PE ratio is desirable as these are growth stocks with potential for significant stock price gains.

The reality is that both interpretations are overly simplified. The first thing investors need to realize is that the earnings for the PE calculation can be either historical earnings or future earnings.

Historical - Trailing Earnings & PE Ratios

The historical earnings are fact as they have occurred but they are less favored by the financial press which tends to prefer to report the future PE based on forecast earnings.

When historical earnings are used the PE ratio is referred to as the Trailing PE. The historical earnings used can be either the last reported full-year earnings or the total of the last four earnings quarters. This is best illustrated with an example as shown in Table 1. with Southwest Airlines Co.

Table 1. Trailing Earnings

Table Trailing Earnings

The Trailing FYE (Full-Year Earnings) for Southwest Airlines is 1.65 for the 2014 fiscal year (with a 31-December end date). The full-year earnings is simply the sum of the four quarters - Q1, Q2, Q3 & Q4.

The Trailing TTM (Trailing Twelve Months) Southwest Airlines is 2.34 which uses the last four quarters - Q2 & Q1 from 2015 and Q4 & Q3 from 2014.

The two trailing PE ratios are the same when the last quarter is the same as the end of the fiscal year. Thus for a 31-December fiscal year the PE is the same when the last quarter is the fourth.

The TTM trailing PE ratio is usually the trailing PE that's quoted on financial websites. The FYE trailing PE is more commonly used when numerous historical years are quoted rather than just the last year. The FYE trailing PE is the PE ratio that's used when StockInvesting.today quotes historical PE ratios.

Future - Forecast Earnings & PE Ratios

The future earnings are usually based on full-year earnings rather than quarterly earnings and they are an estimate of what the company's future earnings might be. Financial websites such as Yahoo provide a future PE which at present is the 2016 PE ratio - for Southwest Airlines the 2016 PE is 10.14

Note that this is the 2016 PE estimate and not the 2015 PE full-year estimate. The 2015 fiscal year has not yet completed and at present has only reported for the first two quarters). The 2016 PE estimate is for one year and a halve years into the future. It is common practice to report future PE ratios by referencing the PE with the year of the forecast estimated earnings - for this example it's the 2016 PE which means the 2016 forecast earnings but the stock price used is the current stock price (not the estimated 2016 stock price).

Stable Earnings - Stable PE Ratios

Most novice investors only apply the PE ratio to a single year rather than looking at the trend over a number of years. The first problem with only looking at a single year is that it's impossible to determine the relative value of the PE - the single year could be a really good year or a really bad year?

The PE ratio makes the most sense when applied over a number of years with stocks that have a reasonably stable earnings history. A stable increase in earnings tends to produce a reasonably consistent PE ratio over the years.

A company with a stable earnings history is shown below in Table 2a. for Roper Technologies, Inc.

Table 2a. Stable Earnings History

Table Stable Earnings History

Referring to Table 2a. above the earnings have been generally increasing over the last ten-years and the historical PE ratio has been fairly stable averaging around 20.

The earnings are plotted on Graph 2a. below to show the stability of Roper Technologies earnings.

Graph 2a. Stable Earnings History

Graph Stable Earnings History

The above earnings graph for Roper Technologies shows a straight line (the green line) drawn through the earnings data points. The earnings mostly follow the straight line and it's this stability in earnings that allows investors to project forward what the likely earnings would be into the future. The straight line projection shows that the earnings would be around 7.00 in 2016.

Yahoo provides a 2016 PE which for Roper Technologies is 21.12 and the investor can use this to calculate the 2016 forecast earnings. The current stock price is 165.71 on 20-Aug-2015. Investors should note that the 2016 PE will fluctuate around as the current stock price fluctuates around. Also the 2016 forecast earnings are typically revised which means the earnings estimates change over time thus altering the 2016 PE ratio. The 2016 earnings can be calculated as follows:

Calculate 2016 earnings:

Stock price = 165.71

2016 PE = 21.12

2016 Earnings = 165.71 / 21.12 = 7.86

The 2016 forecast earnings from Yahoo are 7.86 which is a little higher than the 7.00 projected earnings from Graph 2a. above. Looking back at Graph 2a. there is a good chance that the 2016 earnings are going to somewhere between 6 and 8.

Fluctuating Earnings - Fluctuating PE Ratios

The PE ratio makes less sense with companies that have historical earnings that vary widely. While the earnings may still show a broad upwards trend, a typical earnings pattern is profits for some of the years and losses for the other years. A typical example of a company with fluctuating earnings that are broadly trending upwards is Electronics for Imaging, Inc. which is shown in Table 2b. below.

Table 2b. Fluctuating Earnings History

Table Fluctuating Earnings History

Glancing at the earnings in Table 2b. above shows that the earnings are inconsistent from one year to the next. Also the PE ratios are all over the place.

Some of the limitations with the PE ratio are:

Limitations of the PE ratio:

  • Negative PE values are meaningless. The negative value comes about because the earnings were negative (the company made a loss).
  • Extremely large PE values are meaningless. The 2006 fiscal year had a PE of 2558 but this high value is merely the result of an extremely low earnings of 0.01 - which was only just a profit.
  • Should an earnings figure of zero be booked then the PE calculation gives an infinite - this is because you cannot divide by zero as it gives an error. This means investors must ignore any zero earnings from the historical PE calculations.
  • Excluding the above PE values, the remaining PE ratios still range widely from around 10 up to around 90. This makes it difficult to determine what historical PE ratio would be typical for Electronics for Imaging
  • Using forward PE ratios helps overcome some of the above issues as the forecast earnings used are typically positive values, but the limitations still remain especially with historical analysis.

The earnings for Electronics for Imaging are plotted on Graph 2b. below.

Graph 2b. Fluctuating Earnings History

Graph Fluctuating Earnings History

The above earnings graph for Electronics for Imaging shows a straight line (the green line) drawn through the earnings data points. While the earnings tend to fluctuate around the straight line which is trending upwards, there is a lot of doubt with the reliability of the projected earnings. The straight line projection shows that the earnings would be around 1.00 in 2016 but any figure from 0 to 3 would quite reasonable and possible depending on how optimistic or pessimistic the investor is.

Yahoo provides a 2016 PE which for Electronics for Imaging is 16.85 with a current stock price of 165.71 on 20-Aug-2015. The 2016 earnings can be calculated as follows:

Calculate 2016 earnings:

Stock price = 44.29

2016 PE = 16.85

2016 Earnings = 44.29 / 16.85 = 2.63

The 2016 forecast earnings from Yahoo of 2.63 means that this is an optimistic figure being at the high end towards 3. Optimistic forecast earnings from financial websites such as Yahoo are typical.

Summary

The PE ratio works well with companies that display a consistent earnings upward trend. It is a practical and useful piece of fundamental information that allows investors to select the more profitable companies.

The reliability of any forecast earnings and PE ratios is questionable with companies that display a history of fluctuating earnings. The practical use of the PE ratio now becomes very limited.

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