It is a worthwhile exercise to consider the actual significance of comparing price to earnings and to review its calculation. P/E is found by dividing the current price per share by the latest known earnings per share (EPS).
Price ÷ EPS = P/E
The price is the current price of the stock; and since price may change frequently, P/E is an everchanging ratio as well. Earnings is more elusive because the number is published only periodically, so when you use the P/E you are comparing today’s stock price to earnings that may be far out of date, perhaps by as much as three months. With this in mind, giving value to the P/E should be done cautiously; it may be more revealing to study the P/E trend. Compare price as of the closing date of a quarterly financial statement to earnings as of the same date, and use the trend as a means for judging the stock’s value.
EPS is not an exact value. Because the latest published earnings may reflect a specific seasonal high or low point for the company, using out- dated earnings in the P/E calculation can be quite inaccurate. A retail concern’s fourth quarter may reflect exceptionally high earnings due to high volume in the holiday season. By February, however, volume will be considerably lower. Thus, comparing a February price to December 31 earnings is anything but reliable.
The P/E ratio is a valuable and popular tool. Its actual meaning is de- batable, however, and its value and importance may not be what most people perceive.
Key Point
You may recognize not only a long-term trend in P/E by matching historical dates. This also enables you to judge the stock’s value based on annual cycles and cyclical changes the company undergoes as the year progresses.
The number of shares used in the calculation of EPS may further distort the value of the P/E. If the company has issued shares during the year, calculation of EPS should be based on the average shares issued and outstanding during the period the earnings reflect. If new shares are is- sued exactly halfway through the year, the average is easy to figure. Add the beginning and ending balances, and divide by two. However, if shares were issued on more than one date, or whenever shares are issued during the year, it is necessary to weight the calculation to reflect an ac- curate average for the full period.
To average shares accurately, multiply the number of shares out- standing by the percentage of the year issue date to end of the year. For example, a corporation had outstanding shares of 12,500,000 and issued additional shares three times throughout the year:
Shares Months/Year Multiple Balance January 1 12,500,000 12/12 12,500,000
Issued March 15 2,000,000 9.5/12 1,583,333
Issued July 15 1,000,000 5.5/12 458,333
Issued September 1 9,000,000 4/12 3,000,000
Balance, December 31 24,500,000 17,541,666
In this example the accurate average number of shares outstanding during the year was 17,551,666. If earnings for the year were
$27,446,404, the EPS would be:
$27,446,404 ÷ 17,551,666 = $1.56
D e v e l o p m e n t o f t h e P / E 175
Because earnings levels may vary considerably during a company’s annual cycle, it is unreliable to use one quarter’s earnings and price to identify P/E. To make the ratio accurate, you need to look at a full year’s earnings, compared to year-end price—and apply this over many years to find a meaningful trend.
Key Point
If the price per share at year-end was $23.50, then the P/E would be:
$23.50 ÷ $1.56 = 15
Calculating the P/E is not difficult; it is often included in research reports and published stock pages. The problem, however, is that you have no way of knowing what data were used. As a consequence, you cannot know whether stock-to-stock comparisons or even historical information is reliable. Both sides—price and earnings—may be inaccu- rate based on three important possible problems:
1. The age of the earnings information. Today’s P/E may include cur- rent price but outdated earnings information. For example, if you are reviewing data on March 15 and the earnings were last reported on December 31, then one-half of the equation is nearly three months out of date.
2. Subsequent restatements or adjustments. Corporate earnings are of- ten restated for several possible reasons. An independent audit may disagree with the published assumptions, causing a newly revised earnings summary. If the corporation has subsequently acquired a new subsidiary or sold off a previously owned operat- ing segment, then all earnings have to be revised to conform to the current status (which also reflects current price).
3. The timing of the price level versus today’s price. The published price side of the P/E equation may also be out of date, especially in pub- lished documents. If the price has moved several points in either direction since the P/E was published, then it is also out of date.
Given the complexity of timing for P/E, the ratio is not reliable as a current indicator in most situations. P/E is best used as part of a long- term trend, in which the price and earnings are reported on the same day, such as end of the fiscal quarter; adjusted for subsequent restated earn- ings; and then tracked over time.
The popular use of P/E—based on current price and outdated earnings—can be highly misleading. A long-term approach using consistent data makes more sense.
Key Point
Given the tendency for cyclical changes during the year, looking at a quarter-end price and earnings summary may be unreliable as well. Thus, P/E may be studied over a number of quarters or years as a range of levels.
Standard & Poor’s publishes a STARS Report available at http://www .schwab.com as well as at other sites that reports detailed fundamental and technical information for thousands of listed companies. Among the infor- mation is a range of year-end P/E ratios, both high and low, set up just like the better-known trading range of each stock. Figure 9.1 summarizes a
D e v e l o p m e n t o f t h e P / E 177
2
0 1995
4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34
1996 1997 1998 1999 2000 2001 2002 2003 2004 FIGURE 9.1 Citigroup P/E Range, 10 Years
Source: Standard & Poor’s STARS Report.
10-year P/E range for Citigroup (trading symbol C) reported by Standard
& Poor’s.
To summarize the high and low P/E levels for Citigroup during the 10-year period (based on December 31 levels):
Year High Low
1995 11 7
1996 14 8
1997 23 11
1998 30 12
1999 21 12
2000 23 13
2001 21 13
2002 20 9
2003 14 9
2004 16 13
What can you conclude about Citigroup’s long-term safety, mar- ket perception about the company, or likely future P/E trends? The 10- year record shows not only a consistently moderate range of P/E levels, but even a reduction in the most recent years in the P/E range. When this is accompanied with price range data for the same period, (which has also been fairly narrow), it becomes apparent that Citigroup has ex- perienced very low overall volatility (in price and in P/E) over a decade.
Studying the P/E trend over many years is far more revealing than looking at P/E at a moment in time. A singular P/E level can be very de- ceiving, given the possibility that price moves rapidly in some cases, and earnings may be far out of date. However, studying an annual range over many years gives you a better idea of the P/E trend.
P/E is especially valuable when reviewed over many years and stud- ied side-by-side with the stock’s trading range.
Key Point