13 September 2008

Price to Earnings

The popular (and excellent!) Disciplined Investing blog recently included a post titled, Understanding the P/E Ratio.  It cites an article in the AAII Journal with the subject: Will the Real P/E Please Stand Up

The latter defines seven variations of the Price-to-Earnings ratio, or multiple, on which many investors rely to indicate the expensiveness of a company's common shares.

When buying shares in a company, investors are generally willing to pay a higher multiple of the company's earnings when the prospects for earnings growth (in terms of the annual growth rate and the confidence the investor has that the growth rate will be achieved) are good.  Interest rates affect this calculus since the investor is, in effect, discounting future earnings to the present time.

While we have a lot of concerns about the P/E's validity, we do include what the AAII calls "P/E Trailing Earnings" and "P/E Relative" in the calculation of our Value Gauge score.  Of course, we consider other parameters as well.  We concur with Disciplined Investing's advice -- which, in some ways, is the essence of the GCFR approach -- that P/E ratios should be factored in with other fundamental data when making investment decisions.

One might think that the calculation of any P/E variant is merely simple arithmetic and completely unambiguous.  Share price divided by Earnings per Share.  In today's world, investors can get these figures instantaneously.  However, EPS values required for the ratio's denominator are often adjusted to exclude so-called special items.  

The exclusion is not inherently bad because one-time gains and losses can distort impressions of the company's performance.  However, unless one traces the earnings back to the Income Statement, it's not always clear exactly what has been excluded. 

When looking up the EPS figures for different companies in an industry, investors should assure themselves that the same types of exclusions have been made to each value.

We also tend to be very suspicious of all calculations involving future (i.e., forward) earnings.  If we've forecast a company's future earnings, we know (and explain to our readers) what assumptions we've made.  We almost never have this knowledge about the earnings predictions that are so easy to find on the Internet.

At GCFR, we stick to GAAP earnings when computing EPS.  We don't exclude special gains/losses, although we sometimes make adjustments for discontinued operations and changes in the application of accounting principles.  If a one-time gain/loss is especially large, we might temporarily omit it in a what-if analysis and then put it back in.

1 comment:

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