P/E (Price-to-Earnings) Ratio Explained

Math

P/E Explained
August 6, 2018

In Last Week's Blog we briefly covered valuation and why investing based solely on the price per share is a terrible strategy. One metric that will definitely help you understand why that is: the P/E or "Price-to-Earnings" Ratio.

The formula for P/E is very simple: Price Per Share/Earnings Per Share

But what does that mean? Basically, Price per Share is the current stock price. So if you google "AT&T Stock Price", that is the input you will use. Now, Earnings Per Share is a little more tricky because that data requires a bit of digging. You want to have 12 months (4 quarters) of earnings before calculating a P/E ratio.

In this case, AT&T makes it easy for us to compute by providing this awesome presentation: Click Here to See the Presentation. On page 2 there is a row named "Diluted EPS Attributable to AT&T", that is what we want!

*Q2 2018 just ended, so as soon as Q3 2018 rolls around this data will be obsolete and you will have to get the most recent presentation from AT&T's investor relations site*

We need to gather the last 12 months of earnings (Quarters 3 and 4 from 2017, and Quarters 1 and 2 from 2018) and add up the "Diluted Earnings Per Share" numbers. Diluted means it takes into account the "convertible" securities. This includes securities that are not shares yet but could be turned into shares at any moment, like stock options, warrants, preferred shares, convertible debt, and the like. You don't need to worry too much about the nitty gritty of why we want to calculate for the dilutive effect of those securities. Just know that a good rule of thumb is to keep all of your calculations the same. This means if you use Diluted EPS for AT&T, make sure to use the same when calculating the P/E for Verizon, T-Mobile, etc.

For AT&T, the past 4 quarters of EPS were:

Q3 17 DEPS: $.49

Q4 17 DEPS: $3.08

Q1 18 DEPS: $.75

Q2 18 DEPS: $.81

Last Twelve Months (LTM) Diluted EPS: $5.13

Latest AT&T Stock Price (8/5/18): $32.28

P/E Ratio = PPS/EPS = $31.97/$5.13 = 6.29

There you have it! AT&T has a current P/E Ratio of 6.29. So now you must be thinking: "Cool, but so what?" Well this information is important because the P/E ratio tells you how much YOU are paying per dollar of earnings the company makes. In this case, we are paying 6.29x for every $1 AT&T makes for us, which is a pretty good deal. Some companies have astronomical or even negative P/E ratios. During 2009, the Average P/E Ratio of the stock market peaked at over 120! You can check out the historical P/E Ratio of the S&P 500 index at the Link HERE.

If you do check out that site, you will see that the Current Market P/E is around 24.5 and the Historical Average P/E ratio is about 16. This means that any time the S&P500 P/E is below 16, you are getting stocks at a below average P/E. If it is above 16, you are paying a bit of a P/E premium.

Note that just because a P/E ratio is high does not mean one stock or the whole market is overvalued, it is not the end all be all calculation. It is just a quick gauge to understand how much you are paying for earnings. Obviously you want to pay as little as possible and earn as much as possible, but just because a company has a low P/E does not mean it makes great earnings. You can use metrics like change in Free Cash Flow, Debt/EBITDA, and others to get a better picture of how the company has done over time. Combining these with the P/E ratio will give you a great understanding of where the company is right now and how much you are paying for it.

I hope this article has helped you understand why investing based solely on price per share is a poor decision. I know that when I first learned about the P/E it was eye opening for me because I wanted to get the best deals! I didn't want to pay a high premium for a company's earnings. Don't get me wrong, there are a lot of people who make a lot of money buying and selling high flying, super high or negative P/E companies. That is just not MY style and I wouldn't be comfortable investing that way.

If you think this is too much work, you'll be happy to hear that most financial sites calculate the P/E for you! (I just like to calculate it myself because sometimes they are not using the most up-to-date earnings data.) So by searching AT&T P/E Ratio in Google, I see ycharts.com lists AT&T's P/E as 6.24, which is pretty close to what we got. However, Google Finance lists the P/E ratio as 17. Why? Because they are using Earnings Per Share Forecasts from AT&T's management against today's stock price. This is called the "Forward" P/E and it is a forecasting tool to see how much you are paying NOW for estimated future earnings. I use the current P/E, rather than the Forward P/E, because we do not know what AT&T's stock price is going to be in 3-6-12 months. With the uncertainty of future price, I think it is silly to use forecasted future earnings.

Remember that there is no silver bullet in investing. There is no "One Thing" that can tell you if a stock is going to go up "FOR SURE". If someone tells you there is, they are lying through their teeth. What we CAN do is combine these measures of price and value to put ourselves in the best possible situation with the highest likelihood of success! If you are interested in learning more about value investing, check out The Intelligent Investor: The Definitive Book on Value Investing

MDAS

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P.S. New blog posts coming your way every Monday!

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