the P/E ratio
As mentioned in a prior chapter, early in the twentieth century US investors started comparing share prices to profits: dividing the company’s market capitalisation by last year’s declared profits. Equivalently, at the per-share level they could divide the share price by the EPS. This gave them a rough-and-ready estimate of how many future years’ earnings they were paying in order to own part of the company.
Typical P/Es encountered when the market is neither particularly high or low are in the range of 8-12, i.e. you are paying 8-12 years’ worth of future earnings in order to own one share now. As we shall see in a later chapter, however, this varies according to several factors:
The average P/E of the market itself waxes and wanes with overall market confidence, as Figure 1 shows. The FTSE 100’s P/E peaked at 30.5 in the technology stock boom in early 2000, but fell to a low of 7.2 at the nadir of the banking crisis in early 2009.
Figure 1: FTSE 100 P/Es, 1993-2012
Large companies generally have higher P/Es than small companies. I am not aware of any accepted explanation for why this is. In my opinion it is probably due to the fact that fund managers investing billions have little choice but to invest in the largest companies: researching hundreds of sub-£50m companies simply isn’t worth their time.
Figure 2 is a scatter plot of the market capitalisations of individual companies versus their P/Es. This is for all 974 quoted UK companies that had a P/E on one day in 2012. Due to some extreme values I have taken logarithms of all the data points.
Figure 2: Market capitalisations versus P/Es for all UK companies. (7 February 2012)
As can be seen, the P/Es do cluster around the 10-20 mark. Given that the scatter plot shows almost 1000 companies, very few have a P/E over 100 (log10 of P/E > 2). The red line is the line of best fit: other things being equal, you would expect a company with a market capitalisation of £10m to have a P/E of 10.4. Since the logarithms are base 10, this company would be near point (1,1) in the scatter plot. On the other hand, there are three giant companies (circled) with market capitalisations close to £100bn, or £105m. According to the line of best fit you would expect these to have P/Es of 21.3, but in fact they have relatively low P/Es for their size, of 9.9 (HSBC), 6.3 (BP) and 11.3 (Vodafone).
Companies in particularly exciting high-growth sectors can also have very high P/Es of 20, 25 or more, even when there is no market bubble in operation. This is because of that future growth: if you are confident that a company will be growing strongly for years to come, then you should be prepared to pay a higher price now for a share of that growth. The high P/E is justifiable, provided that the expectation of long-term high growth turns out to be correct.
Historical and prospective P/E
Historical and prospective P/Es are calculated on the basis of the historical and prospective EPS:
Thus if a company earned 3p per share according to the most recent annual report and the share price closed at 24p yesterday, then the shares cost eight times a single year’s earnings and the company has a historical P/E of 8 (sometimes written as ‘8x’).
This is the most widely quoted figure, and the one that will be used in any academic research into how well P/Es predict share price returns, but it can be seriously out of date. In the worst case, the preliminary results for the company year just ended might be about to come out (and 120 days of grace are allowed before preliminary results must be published), but the EPS quoted is still that from the previous company year. So the historical P/E could be based on some items sold and costs incurred up to two years and four months ago.
A more up-to-date but less reliable P/E is the prospective P/E:
This is more up to date than the historical P/E because it is based on earnings expected by analysts over the current company year, i.e. sales currently taking place and costs currently being incurred. However, it is less reliable because it is based on analysts’ forecasts rather than accounting fact. Also, as explained in the previous chapter, the forecast EPS is only calculated if at least three analysts are following the company. Many small (sub-£50m market capitalisation) companies will likely only have their house analyst following them, and so do not have a prospective P/E. Historical back-tests of investment rules that want to use the full range of companies quoted on the stock market can therefore only use the possibly out-of-date historical P/E.
Example
Table 1: Inchcape and Haynes EPSs and P/Es, February 2012
Table 1 shows the different P/Es that can result. Inchcape’s earnings’ forecasts rise steadily over the next two years, so the P/E drops gradually. Haynes with a market capitalisation of £19m does not have enough analysts following it to have a prospective P/E quoted, so has only its historic P/E of 6.7.
Earnings yield and the E/P
Earnings yield is simply the inverse of the P/E, expressed in percentage terms. It gives a figure analogous to the bond yield, except for the fact that the earnings go initially to the company, not the investor. (Dividend yield is more closely analogous, since the shareholder actually receives the dividends.)
If one share costing 24p gave 3p EPS:
The earnings yield (without the percentage format) is universally used instead of the P/E in academic research. There it is referred to as the E/P. This is not just because finance researchers love technical jargon: the P/E has a nasty discontinuity in it. A share price can never go to precisely zero but EPS can, so you want EPS as the numerator, not the denominator. Consider a company with a share price of £10 that made +0.1p EPS last year:
If the same company makes just a few pounds less and hence a 0.1p EPS loss:
The P/E has gone through a discontinuity as the EPS passes through zero when the E/P has not. This is likely to cause problems when assigning companies to portfolios based on their P/Es, hence the E/P is used instead. Many studies in fact exclude loss-making companies altogether: although a (negative) P/E can be calculated if a company makes a loss, it is intuitively difficult to think what a negative P/E means.
Chapter 4. Practical Calculation of EPS and the P/E from Company Accounts
We
