- CFAI focuses on leading P/E and trailing P/E, so follow those for exam purposes, as they are presented.
- The P/E ratio is useful because: it attempts to value a company based on its earnings power; the P/E ratio is easy to understand; it is widely followed; and it can assist in estimating investment returns.
- The P/E ratio can be criticized because: it does not work for a company with negative earnings; it can be misinterpreted for companies with inconsistent earnings; and it can easily be manipulated by company management through discretion allowed under accounting standards.
Trailing P/E Issues
- Non-recurring items: Whenever looking at a company's trailing P/E ratio, analysts should revise earnings to exclude non-recurring items.
- Cyclical companies: Whenever analyzing companies whose earnings are highly sensitive to the business cycle, analysts need to normalize (or smooth) earnings; this can be done with average ROE, for example.
- Accounting practices: Analysts must be aware that a company's accounting may require revisions so that historical accrual based earnings reflect economic reality.
- Dilution: A company's stock may have dilutive exposure and basic EPS might not reflect the actual EPS that investors would see in the future as the number of shares outstanding could grow through exercised options, convertible securities, etc.
Leading P/E and Earnings Yield
Leading P/E
This ratio will reflect a company's future earnings, possibly the next fiscal year or next four quarters (if a company is in the middle of a fiscal year). A leading P/E can be in year as well, reflecting some portion of year to date earnings and forecasted earnings for the remainder of the year.
Earnings Yield
Earnings Yield = Earnings per share / Price per share
- This is the inverse of the P/E ratio.
- Unlike the P/E ratio, it can be used when a company has negative earnings.
Gordon Growth Model (GGM)
Gordon Growth Model (GGM) and Trailing P/E Ratio
- GGM can be used to show how variables influence trailing P/E.
P0/E0 = (Dividend payout ratio × (1 + Growth rate)) / (rce - g)
GGM and Leading P/E Ratio
P0/E1 = (Dividend1 / Earnings1) / (rce - g)
- As the growth rate goes up a stock's justified P/E increases.
- As the required return on common equity goes up, the justified P/E decreases.
P/E to Growth Ratio (PEG Ratio)
PEG = (Leading P/E) / g
NOTE: g = earnings growth rate and the calculation requires the percentage form and not the decimal form (leading P/E should be a whole number above 1).
- Stocks with high PEG multiples are considered to be less desirably priced than stocks with low PEG multiples.
- The PEG ratio can be misapplied because: it assumes that the P/E ratio and the growth rate have a linear relationship; it does not account for multiple periods of different growth rates; and it does not reflect different levels of risk across different companies.
Terminal Values and the P/E Ratio
- When performing multi-stage dividend discount or discounted cash flow modeling, a benchmark P/E ratio can be applied to the firm's forecasted earnings upon reaching a stable growth period.
Trailing Terminal Value: Vn = (Benchmark Trailing P/E) * Earningsn
Leading Terminal Value: Vn = (Benchmark Trailing P/E) * Earningsn+1
- These approaches will generate the terminal share price value for the period n (if trailing P/E is used) or period n+1 (if leading P/E is used).
