PRICE-EARNINGS RATIO Many investors are interested in how the earnings are valued by the mar-

PRICE-EARNINGS RATIO Many investors are interested in how the earnings are valued by the mar-

ket. A measure of how these earnings are valued is the price-earnings ratio (P/E). This ratio compares the price per common share with earn- ings per common share:

Market price per share

Price-earnings ratio = -----------------------------------------------------------

Earnings per share The result is a multiple—the value of a share of stock expressed as a

multiple of earnings per share. The inverse of this measure is referred to as the earnings yield, or E/P: 24

20 Edwin Elton and Martin Gruber, “Earnings Estimates and the Accuracy of Expec- tational Data,” Management Science (April 1972), p. B-423.

21 Coggin, “The Analysts and the Investment Process: An Overview.” 22 Jeffrey S. Abarbanell and Victor Bernard, “Tests of Analysts’ Overreaction/Under-

reaction to Earnings Information as an Explanation for Anomalous Stock Price Be- havior,” Journal of Finance (July 1992), pp. 1181–1208.

23 Robert Conroy and Robert Harris, “Consensus Forecasts of Corporate Earnings: Analysts Forecasts and Time Series Methods,” Management Science (June 1987), pp.

724–738. 24 Though the earnings yield provides the same information as the price-earnings ra-

tio, it is often used to avoid the problem of dividing by zero in the cases in which earnings are zero.

Earnings Analysis

Earnings per share

Earnings yield = -----------------------------------------------------------

Market price per share Because investors are forward-looking in their valuation, earnings

per share in this ratio represents the expected normal earnings per share for the stock. If a company has a share price of $17 and earnings per share of 80 cents, the price-earnings ratio is:

Price-earnings ratio = ------------------ =

21.25 times

and the earnings yield is:

$0.80 Earnings yield = ------------------ = 4.71% $17.00

If the market value of the stock represents today’s forecast of future earnings to common shareholders and if current earnings are an indica- tion of future earnings, this ratio tells us that each dollar of earnings represents $21.25 of value today.

P/E ratios vary over time for the S&P 500, typically ranging from 8 to

20 times, averaging around 14.2 times as illustrated in Exhibit 23.6. In recent years the P/E ratio has gone out of these bounds, reaching record- breaking highs toward 30 times. 25

An interesting issue arises in deciding the appropriate inputs to the P/

E ratio. The numerator is rather straightforward: Use a recent market price per share. The denominator presents a number of issues. Aside from the issue of whether the denominator is the basic or diluted earnings per share, an important issue is over what period to measure earnings per share. At any point in time, the most recently ending annual period or quarter’s earnings may not be available. Further muddying the waters is whether the P/E ratio should be measured over a historical period (back- ward-looking) or measured using forecasted earnings (forward-looking). So what is the analyst to do? There are several approaches that are used:

■ The sum of the latest available four reported quarters.

25 See John Y. Campbell and Robert J. Shiller, “Valuation Ratios and the Long-Run Stock Market Outlook,” Journal of Portfolio Management (Winter 1998), p. 11,

and E. S. Browning, “Bulls Use Convoluted Measures to Justify View,” Wall Street Journal (April 20, 1998), p. C1.

FINANCIAL STATEMENT ANALYSIS

EXHIBIT 23.6 Average Annual P/E for the S&P 500, 1958–2001

Source: Standard & Poor’s Stock Market Encyclopedia and www.standardandpoors.com. ■ Estimated earnings for the next fiscal year.

■ Earnings per share averaged over several historical, annual periods. The last approach is suggested by Graham and Dodd and uses an EPS

that is the average of EPS for “not less than five years, preferably seven or ten years.” 26

Taking a closer look at the determinant of P/E ratios, we see that this ratio is related to a number of fundamental factors:

Factor

Relationship with P/E

EPS growth

Stability of earnings growth

Earnings quality

Dividend payout

Financial leverage

Market capitalization

P/E ratio of similar stocks

P/E ratio of the market

Level of interest rates

Inflation

26 Benjamin Graham and David L. Dodd. Security Analysis (New York: McGraw- Hill, 1934), p. 452.

Earnings Analysis

As pointed out by Eugene Fama and Kenneth French in their study of the relation between stock returns and fundamental factors, E/P (or its inverse P/E) includes the stock price in its construction and hence should

be correlated with stock returns. 27 This has been supported in research that finds that E/P explains stock returns. 28 Additional evidence of this is found in Chapter 9 where we discuss fundamental factor models.