From the October 2007 issue of Wealth Manager Web • Subscribe!

October 1, 2007

P/E Revisited

"It's selling at 10-times earnings. It's cheap!" We have all seen or heard this many times. We've probably even said it once or twice. And when considering an investment, it is certainly wise to look at some metric of value. How much will you pay today for a stream of future earnings?

And, yes, future interest payments on U.S. Treasury Bonds are more exact and more certain than the earnings of a new startup company. Both are investments, and each might be appropriate for certain clients, depending on circumstances such as age, income, risk tolerance, inflation, etc. You know the drill.

For bonds, we calculate "present value" --the value today of an amount of money in the future. This includes the interest payments for the life of the bond and return of principal at maturity.

For stocks, we use price-earnings (P/E)--a valuation ratio that compares a company's current share price to its per-share earnings. It seems like the simplest ratio to compute. You divide the price of a share by the earnings per share, and you get a number. What could be easier?

For example, if the shares of a company are currently trading at $40 and earnings over the last 12 months were $2 per share, the P/E ratio for the stock would be 20 ($40.00 / $2.00 = 20).

Unfortunately, that number could be totally worthless--for you and your clients--unless you understand how the earnings were calculated. If you were in the middle of a year, would you use last year's earnings or the last four quarters' earnings? Perhaps you would use the projected earnings for the current year.

As you can see, each different earnings figure could yield a different P/E multiple.

Other Earnings Determinants

How does the company account for a sale? Do they consider a sale to be made when the order is taken? Or when the deposit arrives? Or when the finished goods or services are delivered? Or when the customer's final check clears the bank?

It's easy to determine the timing of a sale when you walk into a store and purchase something with cash. But what if you subscribed to a magazine or a newspaper? Your final issue is probably still a tree right now. When should the company book your subscription as a sale? How would you compare the P/E multiple of a company that booked the sale and earnings when you paid against a company that booked the sale each month or at the end of your subscription?

What if the product was one of the new Boeing 787s? You could order it today; Boeing would start building yours in 2009, to be delivered in 2010. What about a new plant? You could let the contract today, and it would be built over the next three years. How do you account for the cost? And how does the builder account for the income?

What about inventories? In times of highly fluctuating raw material costs and finished goods prices, the difference between LIFO (last in, first out) and FIFO (first in, first out) inventory accounting would have a big impact on costs and, therefore, on earnings.

As you can see, varying, yet totally acceptable accounting practices can make comparisons difficult, if not impossible, between companies.

Why a P/E anyway?

When a company has a high P/E, it usually means that investors are expecting faster earnings growth than they would of a company with a lower P/E. That's why technology stocks generally have higher P/Es than electric utility companies.

But that's not the whole story. How does the ratio work when a company has very little or no earnings, or is losing money? In these cases the P/E ratio can range from gigantic to infinite to meaningless.

Take this example: A copper mining company stock was selling at $20 a share, and earnings were 10 cents a share. Two-hundred-times earnings is really a very high multiple. In the following year, the world economy expanded, and the need for copper increased. The price of copper exploded, and almost all of the increased price of the metal flowed directly to the bottom line. You would expect that to happen since the cost of mining the metal pretty much stayed the same. The only change was that the price of copper on the London Metal Exchange increased.

The stock quadrupled to $80 per share. Per share earnings were forecast to increase to $8 from 10 cents. The stock was called "cheap" by the press and by the public because it was selling at only 10-times projected earnings. Experienced metals analysts knew that the higher price would cause reduced usage at the same time this price would encourage expanded production. The up cycle in the price of copper was ending--not beginning. When the P/E was 200, the stock was actually cheaper than when the ratio was 10.

The important concept to learn here is that we cannot look at any one number--especially the P/E ratio for any company--without comparing it to itself over a longer period of time than today's one snapshot. And to get a better understanding of relative value, you should compare a company's ratio with the ratios of other companies in the same industry.

The PEG Ratio

The PEG Ratio compares a company's price/earnings ratio to its expected future growth. To calculate the PEG Ratio, you divide the P/E by the anticipated growth. If a company has a P/E ratio of 20 and is projected to grow at 20 percent a year, its PEG is one.

Generally speaking, the lower the PEG, the better. Do the math yourself. Ideally, you want a company with fast growth and a relatively low P/E.

By looking at PEG ratios, it is possible to compare the relative value of very different companies. For example, a company with a P/E ratio of 15 that is growing at 15 percent a year and a company with a P/E ratio of 25 that is growing at 25 percent a year, both have a PEG of one.

Remember, just because a stock is trading at a low P/E does not mean that the stock is undervalued. A stock may be trading at a low P/E because investors are less optimistic about its future.

None of these numbers lives in a vacuum. You need to calculate the ratios, add a few grains of salt for the underlying accounting and the future projections, compare the company's ratios to itself over time, and then compare all of these ratios to similar companies, dissimilar companies, and to the market averages as a whole.

Gary Wollin (www.garywollin.com) is a Warren Buffet-style investment advisor with 45-plus years of Wall Street experience. Regularly featured in The Wall Street Journal , New York Times and other publications, he writes and speaks on sales, customer loyalty and the stock market.

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