Educational Programming Video
The Value Line Investment Survey
Program 7: Value Line's Price/Earnings Ratio
This begins the first of a number of lessons devoted to discussing the price/earnings ratio. The price/earnings ratio, which is often abbreviated as P/E Ratio or simply P/E, is probably the most widely used statistic in investment analysis. Because of its wide use, all investors should know about it. Value Line actually shows six different versions of the statistic on each full company page in The Value Line Investment Survey.
At the top of each page we show the P/E Ratio, the trailing P/E Ratio, the median P/E Ratio, and the Relative P/E Ratio. In the large statistical section in the center of each report, which we call the statistical array, we also show the Average Annual P/E Ratio going back for many years and the Average Annual Relative P/E Ratio for the same years. In the statistical section, we also estimate what the Average P/E Ratio and the Relative P/E Ratio will be in a period 3 to 5 years in the future.
We'll start with a discussion of the simple P/E Ratio. The important thing to know is that all P/E Ratios are calculated by dividing the price of a stock by 12 months of earnings per share. The price used in the calculation is almost always the most recent price available, but the 12 months of earnings can be for very different periods. Some use the reported earnings for the most recent 12 months; others use the earnings for some period or periods in the future, usually a company's fiscal year.
For our P/E Ratio, which is shown at the top of each company page, Value Line uses the total of a company's most recent six months' earnings plus the next six months' projected earnings. This means that the Value Line P/E Ratio is based partly on reported actual earnings and partly on projected future earnings.
We should point out here that the earnings that Value Line reports for companies are what we call "normalized" earnings, that is; they exclude large unusual, one-time gains or losses. We believe that the use of normalized earnings provides investors with the best picture of the actual ongoing profit picture of a company. We will talk more about normalized earnings in a future session.
We also want to point out that in the text in various places in our publications, we often refer to the P/E Ratio as the P/E Ratio, but we also sometimes refer to it as the "current P/E" or the "recent P/E." The terms P/E, current P/E, and recent P/E are interchangeable.
Once you know what a stock's P/E Ratio is, you will probably want to begin to determine if the stock's P/E is too high, two low, or just about right. Trying to figure whether a stock is overpriced underpriced, or reasonably priced is at the heart of all investment decisions, and we will talk quite a bit about this subject in coming sessions. We could actually spend weeks discussing it, but we obviously don't have time for that, at least now.
It is worth pointing out, however, that there are usually reasons why one stock will sell at a very high P/E Ratio and another at a low one. (As a guide, you can find the median P/E of all stocks with earnings in The Value Line Investment Survey on the front cover of each week's Selection & Opinion.) The stocks with the high P/Es are normally viewed as having something special going for them, and that special thing is usually, but not always, above-average sales and earnings growth, or at least the potential for above-average growth. And the P/E will be influenced by whether the expected sales and earnings growth is likely to be steady or if it will last for only a short time. There are occasionally other reasons for high P/Es as well, such as the possibility that a company is a possible acquisition candidate, but growth is most often the key.
The stocks with low P/Es are usually the ones with little going for them. The companies are usually perceived as having very low sales and earnings growth potential. They are typically in industries that will grow no faster than the economy, and they may face strong competition either in the U.S. or from abroad. The companies may also carry relatively high debt loads.
In between these extremes are the companies and stocks that are "average." They are the ones that should do just about as well as all the others, with no special reasons for above-average or below-average growth. The great bulk of all companies included in The Value Line Investment Survey fall in this middle group.
The key to being a great investor is buying stocks whose P/E Ratios will increase because some underlying conditions are changing or, alternatively, selling stocks whose P/E Ratios are likely to narrow. More about that later.
In our next session we will discuss Trailing and Median P/E Ratios, and tell you why the P/E Ratios you see in the newspaper may be very different from the ones Value Line shows.
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