Today we've prepared some slightly more technical material for you, starting a series of articles about fundamental analysis of markets and companies. In the first place, we will explain Price/Earnings ratio. It is hardly surprising that it is probably the most popular indicator, and yet so often misinterpreted.

Price/Earnings

By acquiring shares of a particular company, we become its shareholders. When its market value increases, share price also increases, and vice versa, when the company loses its value, its shares become cheaper. Buying shares of any company only makes sense if we assume that it will grow and will be increasing its profits. The company may pay dividends to its shareholders, but not if it decides to reinvest all earned money. In both cases, profits are strength of the company and the indicator discussed today refers to them.

P/E or Price/Earnings is nothing else than the current price of the company shares divided by its Earnings per Share (EPS). Therefore, if P/E is 10, it means that investors are willing to pay 10 USD for every 1 USD profit generated by the company. How on the P/E basis can we determine whether given share are currently undervalued (cheap) or overvalued (expensive)?

First of all, we can refer to market indices. For example, if we look at historical P/E for the S&P 500 index consisting of 500 largest companies listed on the New York Stock Exchange (see chart), we note that the price/earnings ratio ranged from 6 in 1948, up to 120 during the 2008 Great Financial Crisis. When we find an average, then it turns out that for the U.S. it is about 15 and this level is usually considered neutral in the United States. Accordingly, all companies with P/E lower than 15 are treated as undervalued and those with higher P/E are overvalued.

source: macrotrends.net

In fact, based on historical average, it is easy to refer to the entire market, but if we are going to invest in really cheap companies and not only limited to the U.S., we should adopt slightly more restrictive criteria. The following list shows P/E ranges that we use:

source: own elaboration

As you can see, we are a bit more strict, mainly because P/E for the U.S. market is one of the highest in the world. In addition, if we only take into account the last 10 or 20 years of the S&P 500, the average P/E would be even higher, which automatically raises our limits. This is best evidenced by the fact that once the Price/Earnings ratio at 20 was considered very high, and nowadays many people claim that this is a neutral level.

In the end, it is better to adopt more conservative criteria and not change them as speculative bubble develops.

P/E during the crash

Price to earnings ratio is a great tool that facilitates companies valuation, but also has drawbacks. First of all, it is very sensitive. Traditionally calculated P/E or Trailing P/E compares share prices to earnings per share earned in the last 12 months. Usually, companies' earnings are reported quarterly. Therefore, even a short-term drop in profits or incurring a loss significantly increases P/E value.

The graph below shows that the highest P/E for the S&P index did not occur during a speculative bubble growing period but immediately after its burst. This is because, during a crisis, share prices may drop by, for example, 50%, but at the same time company's earnings drop by 90%. Consequently, the P/E ratio is rapidly growing.

source: multpl.com

An inexperienced investor looking at the above chart could come to a conclusion that at the end of 2008 we had to deal with extremely expensive shares (high P/E ratio). In fact, it was not true. Stock valuation was low, but the crisis caused companies to start generating losses, thus raising the value of the indicator to 120 (the highest in history).

P/E vs CAPE

Because of the short-term P/E distortions, it is often replaced with another indicator. CAPE works similarly to P/E, however, it divides the current asset price by average earnings from the last 10 years adjusted by the inflation rate. Thanks to this, CAPE gives somewhat more reliable results, especially in the long term.

Although CAPE is based on price/earnings, in extreme cases we can face huge differences between these two indicators. The table below presents current CAPE and P/E ratios for two countries, Ireland and Greece.

source: own elaboration based on starcapital.de

Recently, Ireland has experienced a real economic boom due to Brexit and tax law reform. This market is already after strong price increases and in the long term very expensive as indicated by CAPE. However, almost 30% decreases from 2018 caused that current P/E for Ireland is only 15. On the other hand, Greece has negative CAPE, because since 2009 it has been struggling with economic recession and companies on the Athens stock market were generating losses. Despite this, its P/E is positive, because over the last year the situation in Greece has improved, and companies are again profitable.

Although P/E and CAPE can differ significantly, in both cases there are very valuable indicators. According to starcapital.de survey, markets with high CAPE bring low returns or even a loss over the next 10-15 years.

source: starcapital.de

Note that in the case of CAPE between 0 and 10 we can expect 12.3% returns on average, while in the case of CAPE> = 30, return is almost zero. The lower CAPE, the better returns, and vice versa.

In case of P/E, this relationship is not as large as in the case of CAPE, but it remains significant.

source: starcapital.de

Negative P/E

There were a lot of doubts about negative values ​​of P/E. In fact, if we are dealing with negative indicator, it means that a particular company or market generates losses and, in general, we should avoid investing in such assets. However, there are exceptions to this rule. The first ones may be commodity-related companies.

In the event of commodity price falling, company producing this commodity generates losses, either by selling the product below the extraction price or by ceasing sales in anticipation of better prices. This usually ends with very rapid but short-lived decrease in P/E ratio to negative values. A great example here is ETF PICK which consists of companies which mainly supply steel and copper.

In mid-2017, P/E of this ETF was -26, because most companies in their compositions suffered due to iron price drop by almost 40%. In mid-2018, when the price of this commodity significantly rebounded, price/earnings for PICK also improved and amounted to 12. It is worth noting that from mid-2017 until the fund came out "into positive territory", price of the ETF shares increased by over 38 % (see graph). Even after such strong rises, PICK was still relatively cheap based on P/E. Thus, we can see that the purchase of an asset with a negative P/E does not necessarily mean a bad investment.

source: stockcharts.com

Negative P/E may also be justified in case of young companies. It is assumed that every company may and probably will bring losses at the beginning of its operations. Start-ups newly listed on the stock market very often have negative P/E. These are the companies in development phase and it is common that investments absorb the majority of their capital, and their product is not mature and has not yet met positive market reaction. In case of such projects, negative values of the indicator are usually very large - 100 and more. They should not, however, be as frightening as the negative values of a dozen or several dozens, but long-lasting.

When negative P/E is dangerous?

Young companies entering stock exchange (IPO) are to some extent justified, but companies that have been operating for a long time and burning out investors' capital are not. An excellent example can be Tesla, which is listed on the New York Stock Exchange since 2010, and yet almost always reports losses both quarterly and yearly. As can be seen in the chart below, earnings per share generated by the company is usually negative.

source: macrotrends.net

P/E for Tesla provided by most sources is "0" or "N/A - Not Applicable". In reality, this does not mean that the company is cheap, or that the index has not been calculated. It means that the company has been incurring losses for at least 12 months. Its actual P/E ranges from -30 to -50, from almost a decade (!)

Determining negative P/E with the "N/A" symbol and not including it in the analysis sometimes creates a lot of problems not only with company valuation but mainly with ETFs and actively managed investment funds. Their issuers are very often using the ratio description which is convenient to them.

A good example here is iShares MSCI Poland ETF with "EPOL" ticker. Fund invests in companies from WIG20 index. P/E for this index is currently over 20 and is historically very high.

Meanwhile, EPOL issuer shows P/E = 12.58 despite investing only in companies that are part of the WIG20. Where does the difference come from? Reports generated by the issuer of the ETF ignores results of companies generating losses. Consequently, price/earnings ratio for the entire portfolio is significantly understated.

Trailing P/E vs Forward P/E

Because the current value of the company is not valued on the stock exchange, but its future value, so we very often deal with Forward P/E ratio. In principle, we do not see much sense to use it, but because it is so common, it's worth mentioning.

Classic Trailing P/E is based on earnings or losses per share generated over the last 12 months. Forward P/E compares current price with forecasted profits. In other words, analysts or managers of the company determine what financial results will be generated over the next 12 months, and current share price is compared to those predictions.

Problem is that predictions differ depending on who prepares them, and managers are almost always too optimistic and later on they correct their forecasts. The reason they do so is to demonstrate that ultimately the companies' results are always better than expected. We have described this phenomenon in more detail in the article "How do you create results better than expected?"

It is enough to mention that profit forecasts for the next year are really optimistic. Therefore, Forward P/E is almost always lower than the current one. After a time, it turns out that the company is not able to generate such profits as it was assumed and systematically decreases forecasted results. It is done in such a way that the reduced forecast would fall below quarterly announcement of earnings. Ultimately, results achieved by the company are usually better than expected. This entire process is perfectly illustrated by the following graphic.

source: 720 Global

In this case, "Massive Miss" is a huge difference between the original forecast and the actual result. "Respectable Beat" is the profit reported which is above expectations.

How to check P/E - sources

Knowing the current price of assets and earnings per share for the last 12 months, we can easily calculate price/earnings ratio. We do not need to do this, however, because most investment websites contain relatively current data.

In case of companies listed on the New York Stock Exchange, as the best sources, we consider gurufocus.com (which also gives CAPE values) and finviz.com.

When it comes to markets valuation, starcapital.de is uncompetitive. The only disadvantage is that they have quarterly updates.

In case of ETFs, it is best to go to the issuers websites, although data we find there are often created in such a way to make an offer of individual funds look more attractive (see EPOL). If in some cases we do not find value of P/E (for example, Wisdomtree does not provide them), we have to use such services as etf.com or etf.db.

There are of course much more sources, but we have indicated only those which we use most often.

Summary

Price/Earnings is very popular indicator used in fundamental analysis. There is a reason for that - it is clear and simple to calculate. It refers to the actual state of an asset and allows us to quickly determine whether we are dealing with market/company that is expensive or cheap, yielding profits or losses.

P/E also has drawbacks but only some of them are included in this article. It is worth to note that the indicator does not take into account the company's debt, or that profits disclosed by the company may be falsified. There are more examples and the devil is always in the details. Therefore, to avoid mistakes, one must never rely solely on one indicator. Fundamental analysis without considering debt levels, operating margins, dividends, etc. will always be imperfect.