The most commonly quoted valuation model is Price to Earnings (P/E). P/E has uses that vary from determining the valuation of companies, to comparing firms within the same industry, to gauging how expensive firms are versus past time horizons. Relying on earnings per share (EPS) as its basis, P/E has become the most used benchmark.
To calculate fair value using this approach, use the following equation:
Fair Value = EPS * Price to Earnings (P/E) Multiple
P/E Multiple = Dividend Payout Ratio / (Discount Rate – Growth Rate)
Divided Payout Ratio = Dividend / Earnings per Share (EPS)
As P/E has made its way into the mainstream thought process, many have ignored the fundamentals of the model. This leads to some common misconceptions and misuses. By understanding the nuances of the P/E model, informed investors can avoid the common mistakes so many others make. These nuances are:
1. Simplicity– Earnings are an easily identified data point at the bottom of an income statement. This makes the calculation of a P/E ratio easy. However, that ease carries pitfalls. By simply calculating a number, many investors avoid disclosing their assumptions about risk, growth, and payout ratios. As investors, we should not allow ourselves to focus on what the current P/E is, but rather what it should be. By going beyond simple math and focusing on these other critical factors, we perform a more useful analysis.
2. Volatility – Most companies maintain a constant dividend during economic cycles. As earnings ebb and flow with the business cycle, this creates an environment where payout ratios shift and earnings fluctuate. These two factors can result in great volatility in the P/E ratio over time. Investors must determine a method of accounting for this noise.
3. Growth matters– Many investors believe buying companies where the P/E is below the growth rate will lead to instant profits. These investors are mistaken. If a company is very risky, the higher risk level leads to a low P/E and can create an environment where the low P/E is justified despite high growth rates.
4. Proper rewards– The P/E ratio is an increasing function of the payout ratio and the growth rate. Further, it is a decreasing function of the firm’s risk. This dynamic allows for positive factors to increase fair value and negative factors to decrease value.
5. Earnings needed– By definition, EPS are needed for the P/E ratio to be applied. Many new companies will not have earnings during their early years. This makes it very difficult to value new and emerging companies using the P/E ratio.
Price/Earnings models are among my favorite valuation techniques. Academic research has shown that earnings-based models offer the most predictive value. The further one travels up the income statement, the less reliant the model becomes. By using the bottom line, P/E excels.