STEP 5 AND 6
CALCULATING P/E RATIOS
In the next two steps we will be calculating the P/E ratios needed for our final year’s EPS valuation. In step 5 we will calculate the market P/E, and in step 6 we will calculate the relative P/E (sometimes called the P/E relative).
The P/E ratio stands for price-to-earnings ratio. It is a measure of how much investors are willing to pay for each dollar of earnings. It is a widely used valuation measure in fundamental analysis. The P/E ratio is calculated by dividing the stock price by earnings per share.
The P/E ratio by itself is not very useful, which is why we have to compare it to something else. P/E ratios vary greatly amongst industries; what might be a low P/E ratio in one industry will be a high P/E ratio in another.
If you open a stocks profile on just about any website, you will most likely see a P/E ratio displayed somewhere. You might also see a “TTM” next to the P/E ratio. This is how most websites calculate the ratio in the stock profile. TTM stands for Trailing Twelve Months and it means that the P/E ratio you are looking at has been calculated using the trailing twelve months’ earnings. On some occasions you might hear of a forward P/E, which is calculated using forward, or projected, earnings. I believe the most common one displayed on stock profiles is, in fact, the TTM P/E.
Stocks that have negative earnings do not have P/E ratios. We shouldn’t be looking at these stocks in the first place when it comes to our valuation strategy. We leave those for other parts of our portfolio.
CALCULATING THE MARKET P/E
Step 5 in our valuation requires us to calculate the market P/E ratio. Once we have the numbers we need, this calculation is just a one-step process that doesn’t take any time at all. Before I show you how to do this I have to explain what it is.
Think of the market P/E as a macro index that is affected by the attractiveness of stocks in general. For example, anything that affects the overall attractiveness of stocks will affect the market P/E. The S&P 500 is the most commonly used index for the market P/E. If an analyst is going to forecast changes in the market P/E, he or she will need to forecast the major factors that will affect it: changes in corporate taxation, growth rate of aggregate earnings, the liquidity of the market (i.e., how much money is sitting on the sidelines that will eventually move back into the market?), the risk tolerance of investors, etc. The analyst will need to estimate the net impact that all of these factors will have on the market P/E. For example, using a three-year forecasting timeframe (or some analysts use four or five-years), an analyst may estimate that corporate tax rates will decrease, earnings growth rates will increase, and investors will get tired of low-yielding debt instruments and will move their money back into the stock market. All of these things make stocks more attractive (at their current level) and will have a positive impact on the future market P/E as they occur. If the current market P/E is 15.0, the analyst may estimate that the market P/E will be 17.0 in three years.
I’m assuming no one reading this is a seasoned market analyst with the ability or desire to forecast any of these factors. I do very little of this forecasting myself and leave the work to analysts who have more experience and better information. We are not actually going to prepare a forecasted market P/E by ourselves; we are simply going to get readily available numbers and use them to get our projections.
Finding the P/E ratio on a stock is easy. As I mentioned earlier, just about every website that allows you to see a stocks profile will display the P/E ratio. The market P/E ratio, or the P/E for a specific index, is not as easy to find. We are going to use the S&P P/E ratio as our market P/E because it gives us the best benchmark. Finding this is not easy, but if you know where to look, it won’t be a problem. Follow these steps to get the required number.
The first number that we are going to get is the TTM P/E on the S&P and we are going to get this from the Wall Street Journal’s website.
1) Go to the home page of the Wall Street Journal www.wsj.com
2) Click on “Market Data”.
3) Hover your mouse over “U.S Stocks”. Look at the second column under “Index Analysis” and click on “P/E’s and yields on major indexes”
4) The number you are looking for is in the bottom left corner. It is the TTM P/E ratio for the S&P. Make sure you take the number in the first column that is under the date. That is not a projected P/E it is calculated using the trailing twelve months’ earnings.
Once we have our number, what we have to do is find the projected growth rate of the P/E over our forecasting time frame. I mentioned earlier that you don’t need to worry about making your projections for market P/E growth. We are going to get our projections directly from the S&P website. These projections are prepared by a senior S&P index analyst and are probably the best projections available. We are going to get these numbers from the same place we got our expected market return in step one, except that we are going to be downloading a different spreadsheet this time. I’m not going to go through all the steps again on how to get to the S&P website with all the spreadsheets. If you forgot, go back to step one and look under “expected market return”.
1) Hover your mouse over “Additional info” and select the first option, “Index earnings”.
2) Download and open the spreadsheet
3) Select the number that I highlighted in orange under the column heading “S&P 500 5YR PROJ ANNUAL GROWTH %”. This number is the five-year projected annual growth of the S&P 500 index represented as a percentage.
Once we have both our numbers, we can perform our simple calculation. Add 100% to your projected growth rate that you got from the S&P spreadsheet and multiply it by the TTM P/E that you got from the WSJ website. That is all you have to do to get your market P/E, which we will be using again in later steps.
TTM Market P/E ratio from WSJ = 18.28
Projected five-year growth from S&P spreadsheet = 10.62% (100%+10.62%)
Calculation: 18.28 * 110.62% = 20.22
20.22 is the number we are looking for. This is the projected five-year P/E ratio for the overall market. (Round your answer to two decimal places.)
CALCULATING THE RELATIVE P/E
Remember how I said the P/E alone is not a very useful valuation indicator, and that you need to compare it to something for it to be effective. The relative P/E does just that; it compares the company P/E ratio to that of the market. A relative P/E above one will indicate that the stock is trading at a premium to the overall market, and a relative P/E below one means the stock is trading at a discount to the overall market. For example, a relative P/E of 1.15 will mean the stock is trading at a 15% premium to the overall market, whereas a relative P/E of 0.90 will mean the stock is trading at a 10% discount to the overall market.
Calculating the relative P/E requires two different numbers: the TTM market P/E and the TTM stock P/E. We already have the market P/E that we got from the WSJ website. To get the stock P/E, you have to enter the ticker symbol on any website that has the ability to display a stock profile. I use Yahoo! Finance.
To calculate the relative P/E, you will take the CURRENT stock P/E and divide that by the CURRENT market P/E. Make sure that you DO NOT use the projected market P/E that we calculated in the previous step!
TTM market P/E ratio from WSJ: 18.28
TTM stock P/E ratio: 17.42
Since the stock P/E is lower than the market P/E, this means that the stock is trading at a discount relative to other stocks in the S&P. To calculate the relative P/E, divide the stock P/E by market P/E. (Round your answer to two decimal places.)
Relative P/E = 17.42 / 18.28 = 0.95
Since the P/E here is below one, it indicates that our stock is trading at a discount. This exact relative P/E means that the stock is trading at a 5% (0.05*100) discount to the overall market.
CALCULATE THE FINAL YEAR’S P/E RATIO AND PRICE
Final year’s P/E ratio
The final step is to incorporate the market P/E with the relative P/E and then figure the final year’s price. We performed the previous two steps in order to be able to do this one. What you will do here is multiply the final year’s market P/E by the relative P/E. (You will multiply the final number from step 5 and the final number from step 6). Make sure that you use the FINAL year’s market P/E (calculated in step 5) and NOT the current one.
Just to break this down for you and show you what is happening…..
You are multiplying a current valuation with a future valuation. In step 6 we calculated the relative P/E of the stock using numbers with no projections. In step 5 we used projections. The theory behind this is that we are looking at the valuation of where the stock is valued now to where it could be valued in the future, relative to the market.
Five-year projected Market P/E = 20.22
Relative P/E = 0.95
Final-year P/E = 20.22 * 0.95 = 19.21
This number is the reason we performed the previous two steps. This is going to be used to calculate our final year’s price, which we are going to do in the second part of this step.
Final year’s price
As part of this step we are going to take the above P/E ratio that we just calculated and we are going to figure the price of the stock in the 4th year based on this P/E and EPS from step 4.
You will need the EPS for the final year that you calculated in step 4. In the example I used, year 4 EPS was 2.12. You also need the above final year P/E which came out to be 19.21.
For the calculation, you just have to multiply these two numbers together. This will give you the final year’s price before we take the discount factor into consideration (explained in the next step).
Final year P/E=19.21
Calculation: 2.12 * 19.21 = $40.73
I mentioned earlier that year 4 EPS is the most important. It is because it’s also used to calculate final year’s price, and so the most weight in this valuation goes to year 4 EPS.
Put this on the diagram and move to the next step.