Sunday, April 3, 2011

PE Multiples, Part 1: Calculating the PE

Any participant in the financial markets can benefit from an awareness of the price-to-earnings ratio, commonly referred to as the PE ratio or multiple. Even passive viewers of CNBC will hear this term frequently. PE is the first financial concept my father introduced to me. I plan to provide a thorough understanding of this ratio through a series of posts. Trust me, there is a lot one must write in order to fully explore this concept. Also, beyond explaining what it is, I will also add some of my own insights, particularly, how it is both a fundamental and a partially technical figure.

To derive the PE of a stock, simply look up its price and its earnings and divide the two. (Yahoo Finance provided all of the data used in this post.) On Friday, April 1st Exxon Mobil, ticker XOM, closed at 84.72. Its previously reported earnings per share (EPS) was $6.22. Its PE is thus 13.62 [=84.72/6.22]. An investor may want derive this multiple based on the company’s future earnings, which are expected to be $8.37 per share, yielding a PE of 10.12. So, 13.62 and 10.12 are the trailing PE and the forward PE, respectively.

The earnings used in the calculations above was the net income, which is affected by balance sheet asset depreciation, stock compensations, interest paid on debt, taxes and other factors. One may consider those factors not as relevant to the long term profitability of a company, so instead of using net income to calculate the PE, one can use what’s known as operating income. Operating income, which does not take into account the factors mentioned above, is the earnings net of various expenses, like research and development, production costs, marketing and sales, all of which are essential elements of the company’s operations. Exxon’s most recent operating income was 8.42. Its trailing PE based on operating income is 10.05.

To summarize, the PE is the ratio of a stocks price to some measure of its earnings. This measure can be current earnings, future earnings, or operating earnings. Each of those three provides a slightly different perspective on the company so it is worthwhile to inspect all of them when researching a stock. Since the trailing PE is based on historical data, it is a factual measure that requires no estimates. A forward PE, on the other hand, requires an estimate of future earnings, which can be inaccurate. However, the forward PE is more important because markets price stocks based on forward earnings and future expectations in general. Lastly, using operating income instead of net income may better represent the company's fundamentals.

This is a good place to stop this first post. To those for whom this post is elementary, I promise more advanced concepts are to come.

The next topic will be the significance of the PE ratio.

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