Estimating the P/E

One of the main figures that an investor should estimate in the process of valuation is the PE of the company. The details regarding a company’s past P/E ratio is available on many financial web sites. All these are real, past data.The question is how to arrive at the future P/E ratio of the company.

For that, the simplest method is historical analysis – Given below- in a two step format.

Step 1.

The historical P/E ratio of the company is taken and a reasonable present day price-earning ratio is computed.

For example – let’s say the price-earning ratio for ‘A Ltd’ for the past 3 years was 9.00, 7.80 and 8.56. Then, the average price-earning ratio for the company would be (9.00+ 7.80 + 8.56) / 3 = 8.45. We may safely assume that the average price-earning ratio for the past three years is applicable in the immediate future also. In the example I have used 3 but, it’s safe to take 5 or  even 10 year average P/E of the company. By taking a long-term average, you smooth out the noise and bumps.

Instead of averaging the ten, you may also drop the low and the high number of the sample and average the balance eight. The logic is – Companies sometimes have one-time events that can affect net earnings either positively or negatively.. This will distort the P/E. That’s why a removal of the highest and the lowest PE is recommended.

Also take note that during market bubbles, P/Es can be inflated for extended periods of time. Similarly, caution should be used while taking PE figures during market crashes. P/E ratios are also generally higher in a low-interest-rate environment because a company’s cost of capital is lower, and also because investors are more likely to take on the risk of owning equities when bond yields and fixed income rates are low.

Step 2.

Cross section analysis- With the average P/E in hand, the next step is to look at price earning (P/E) ratios of similar competing companies in the industry; and then take a view on whether the average P/E ratio is a reasonable for the company under study. Remember to compare apples –to-apples.

Future PE will be lower than current PE if earnings are expected to grow in the future. Future PE will be higher than current PE if earnings are expected to slow in the future.

CONCLUSION

The above said is an easy and practical method to calculate estimated P/E. There are other methods to calculate expectedP/E which are more complicated and require expert knowledge in accounting, finance and the industry under analysis. The above method works for everyone. Since high quality stocks are commonly favored by stock investor, they are normally high in its P/E Ratio. Stock investors have to pay premium investing in high quality stocks as the demand for it is relatively high.

Since the future P/E also depends on the company’s specific projected growth in earnings per share and its specific risk factors, which are very difficult to project, the best approach is probably to forecast growth rates and then to calculate a target P/E at various potential levels of growth and risk. This may give quite a wide a wide range of target P/E ratios.

You may like these posts:

  1. Estimating EPS-Growth rate
  2. Price to Earnings ratio or P/E ratio
  3. Understanding PEG ratio

2 Responses to “Estimating the P/E”

Mansoor

February 14, 2012 at 11:32 pm

Nice article. Does higher PE also means that stock is valued expensive, and vice versa? Does a very low PE also means that the company might not be doing well?
Can you suggest some website where we can get the historical PE of individual stocks? Thanks.

J Victor

February 15, 2012 at 8:05 am

Yes. However, Interpreting P/E is not that simple.

A higher P/E also indicates that the market is willing to pay more for that stock. The reason for this could be high growth potential, high confidence in the sector and stock etc.. Most of the great stocks trade at higher P/Es. So you cannot take decisions based on P/E alone.

A low P/E may also indicate low future growth and high risk.

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