## Friday, 21 June 2013

### Price/Earnings Ratio - P/E Ratio

Price / Earnings Ratio is defined as market price per share divided by annual earnings per share.

Formula : Price / Earnings Ratio = Stock Price per share / Earnings per share

In general, a high P/E ratio suggests that investors are expecting higher earnings growth in the future. Conversely, a low P/E may indicate a “vote of no confidence” by the market. Historically, the average P/E ratio for the broad market has been around 15. Companies that are losing money do not have a P/E ratio.

Looking at P/E ratio alone is meaningless. While evaluating prospective stock, it is useful to look at the current P/E ratio for the overall market (S&P500), the company's  industry segment and those of direct competitor company to determine if the prospective stock is in the high, low or moderate range .

The P/E is also referred to as the "multiple", because it shows how much investors are willing to pay per dollar of earnings. If a company were currently trading at a multiple (P/E) of 20, the interpretation is that an investor is willing to pay \$20 for \$1 of current earnings.

It is important to note that investors should avoid basing an investment decision on this ratio alone. The earnings are based on an accounting measure of earnings that is susceptible to forms of manipulation, making the quality of the P/E only as good as the quality of the underlying earnings number.

### Trailing Price/Earnings Ratio - Trailing P/E

When you divide a stock's price by the sum of company's earnings over the past twelve months, you get the Trailing P/E ratio.

Formula : Trailing P/E Ratio = Stock Price per share / Trailing Twelve Month's Earnings per share

This ratio values the company based on the past. It is the most commonly used P/E measurement as it is based on actual earnings and, therefore, is the most accurate.

#### Example :

The earnings for Cisco is \$8,041 millions and the total outstanding share is 5,340 millions, therefore the trailing twelve month's earning per share is 8,041/5,340 = \$1.51 and the trailing P/E ratio is \$24.43/\$1.51 = 16.18 (as at 21/6/2013).

### Forward Price/Earnings Ratio - Forward P/E

When you substitute the past twelve month's earnings with estimated earnings for the next year, you get the forward P/E ratio.

Formula : Forward P/E Ratio = Stock Price per share / Estimated Earnings per share

The forward P/E ratio looks at what the P/E ratio would be a year from now, assuming that the share price remains the same. If earnings are expected to grow in the future, the forward P/E will be lower than the current P/E. A company who’s earnings are growing very fast would have a lower forward P/E than a company with slower earnings growth. The primary limitation of forward P/E is that future earnings are only an estimate, and the resulting P/E is only as accurate as the projection.

#### Example :

The average earnings per share estimates for Cisco from msn money for FY(7/13) is 1.83. Therefore the forward P/E ratio of Cisco as at 21/6/2013 is 24.43/1.83 = 13.34.

The forward P/E for Cisco is lower than the trailing P/E, this means that the earnings for Cisco is expected to grow going forward.

### Price/Earnings to Growth Ratio - PEG Ratio

Price/Earnings Growth ratio is calculated by dividing the P/E by the projected earnings growth rate.

Formula : Price/Earnings to Growth Ratio = P/E Ratio / Earnings per share Growth

The P/E ratio used in the calculation may be forward or trailing, and the annual growth rate may be the expected growth rate for the next year or the next five years.

The PEG ratio is a refinement of the P/E ratio and factors in a stock's projected earnings growth into its current valuation. It is considered to provide a more complete picture than the P/E ratio. In general, the P/E ratio is higher for a company with a higher growth rate. Thus using just the P/E ratio would make high-growth companies appear overvalued relative to others. It is assumed that by dividing the P/E ratio by the earnings growth rate, the resulting ratio is better for comparing companies with different growth rates.

According to Peter Lynch, "The P/E ratio of any company that's fairly priced will equal its growth rate", i.e., a fairly valued company will have its PEG equal to 1. If the PEG ratio is less than 1, the stock's price is undervalued, If it is more than 1, the stock is overvalued. Companies with PEG values between 0 to 1 may provide higher returns. The PEG Ratio can also be a negative number, for example, when earnings are expected to decline.This may be a bad signal, but not necessarily so. Under many circumstances a company will not grow earnings while its free cash flow improves substantially.

The PEG ratio's when used with low-growth companies is highly questionable. It is generally only applied to so-called growth companies (those growing earnings significantly faster than the market). The PEG ratio is another way to try and identify undervalued high growth stocks through a technical screen. It should not be used alone to select stocks, and should instead be complemented with a fundamental analysis of the market and company to value the stock properly.

The PEG ratio is a rough rule of thumb, and it's accuracy depends very much on the analyst estimates which are rarely correct. When calculating the PEG ratio, it is best to use a very conservative long-term estimate for growth and the current P/E ratio.

#### Example :

We will be using trailing P/E to calculate the PEG ratio. The trailing P/E is 16.18 as calculated above and the growth estimates for Cisco as per msn money is 9.70%. Therefore, the PEG ratio is 16.18 / 9.70 = 1.67.

If you are using Yahoo Finance, the growth estimate is 8.33% and the PEG ration will be 1.94 instead. As mentioned, the PEG ratio depends very much on the analysts estimates and the difference could be quite a lot. You can perform your own estimates on the earnings growth rate and compare against that of analysts estimtates to decide on a conservative estimates to calculate the PEG. Do remember that analysts estimates are only estimates and they are no guarantee that their estimates is more accurate than yours, and its better to err on the conservative side.