The first question after an investor has determined their goals in terms of risk and return is: which instruments should one choose? More specifically, which stocks should be chosen for the part of the portfolio that is allocated to equity instruments? In general, each stock should be carefully investigated on an individual basis – even Warren Buffet’s Berkshire Hathaway strives to invest only in businesses that “we can understand”.
Still, it is first necessary to identify the scope of potentially interesting companies for a closer look. Usually, a process called stock screening is performed to limit the number of stocks subject to a detailed review. Stock screening is a process of using easily obtainable figures to narrow the scope of potentially interesting stocks. It is common to use the so-called trading multiples to conduct the screening. Multiples take the current stock price into account as well as key data from the company’s financial statements.
The Price to Earnings (P/E) multiple is one of the most popular trading ratios used to value stocks. It shows the number of yearly earnings investors are willing to pay for the company. The stocks of companies with a higher P/E ratio are relatively more expensive than the stocks of companies with a lower P/E ratio. The investor will have to pay more for the same amount of earnings the company makes.
It should be noted that there are two types of P/E ratios. The first is the actual P/E. It can be calculated by using the earnings for the last 12 months prior to the date of valuation. It is usually denoted as TTM (trailing twelve months) or LTM (last twelve months). Usually, the latest quarterly financial statements are used to obtain the earnings; for example, it could actually be earnings from April 2016 to March 2017 if the company is valued in June 2017 and the reports for the second quarter have not been disseminated yet.
Because investors are mostly interested in future earnings, the forecasted P/E is the second type. In this case, the ratio is usually called NTM (next twelve months) and the denominator is the estimate of the company’s net income over the next 12 months. If the forecasted P/E is lower than the actual P/E, the market anticipates that the company’s earnings will increase, all else being equal.
The P/E ratio itself is of little use – it should then be compared with other companies or sectors to determine whether the focus company is over- or undervalued. Stock indices also have P/E ratios and each stock can be compared against the index as well as its peer group.
There are also pros and cons of P/E ratios. The pros are as follows: First, P/E is very common and can easily be obtained for the company of interest using free sources (e.g. Yahoo Finance). Second, P/E uses the company’s profit which (according to theory) should be the most important stock price driver.
The main deficiency is that P/E cannot be used when net income is negative or very low. In the former case, the ratio is meaningless, as investors should indeed be unwilling to pay any price for suffering losses. In the latter case, the ratio will fluctuate widely and may yield incomparable results. The other downside is that accounting profits can be manipulated or include one-off events, while the investor is interested in the underlying “core” profitability.
Is should also be noted that the P/E can depend on one’s investment style. For growth stocks, P/E ratios are usually higher, as investors are more willing to pay for these companies in anticipation of earnings growth (e.g. when they believe that the business model is effective or the product will increase its market share). For value stocks, P/E ratios usually have lower values. Therefore, ratio comparison is effective among the same peer group in which companies share similar characteristics.
There are also some ratios that can be substituted for P/E. When P/E cannot be used because of negative/volatile earnings, there is another popular multiple, Price to Book Value (P/B). It can be calculated as the company’s market capitalization divided by the balance sheet value of equity. This ratio is commonly used for companies with high leverage, such as banks.
Another substitute for P/E is the Price to Sales (P/S) ratio. It is useful to value large, established companies in determining how much investors are willing to pay for a dollar of the company’s sales. This ratio has the advantage that it can be calculated for all companies, since revenue cannot be negative (some exceptions apply to financial companies, such as banks, that do not have sales in the usual meaning of this word).
While there are other trading multiples, such as EV/Sales (Enterprise Value to Sales), EV/EBITDA (Enterprise Value to Earnings Before Interest, Taxes, Depreciation, and Amortization) and many more, we hope you got the idea. To identify companies in which to study in detail, it is common for a stock investor to screen for stocks with a potentially interesting price first. It should be kept in mind that such simple screening process will dismiss companies for which the P/E ratio is high, as the earnings may be affected by one-off events.