Price-to-Earnings Ratios

Balian of Ibelin: How much is Jerusalem worth?
Saladin: Nothing...Everything!
--Kingdom of Heaven

In a recent post we stressed the importance of valuation. Valuation is the process of estimating how much a security is worth, and comparing that estimate to the current market price.

If you are thinking about buying a particular stock, then valuation helps you answer this question: "If I buy this stock, am I getting a good deal?" As with any purchase, you'd rather not overpay. Valuation helps you get 'the most for your money.'

Many valuation methods exist. For stocks, the most popular one is expressed by what is called the price-to-earnings ratio. The price-to-earnings ratio, or 'P to E,' compares the current share price of a stock to its annual earnings (or net income) per share.

P/E = current stock price per share / annual net income per share

Let's demonstrate. Last week I noted that one of my favorite 'anchor' positions is Johnson & Johnson (JNJ). What is JNJ's current P to E? Price is the easy part. JNJ is quoted at about $132/share this morning.

To find JNJ's earnings, locate the company's income statement for the most recent fiscal year. For the year ending 12/31/18, JNJ reported net income (or earnings) of about $15.3 billion. Currently JNJ has about 2.66 billion shares outstanding. Therefore, earnings per share = $15.3 billion / 2.66 billion shares = $5.75/share.

JNJ's price-to-earnings ratio, then, is $132 / $5.75 = 22.9.

Usually, you won't need to grind out these calculations in your everyday investment research. P/Es are such popular metrics that most investor info sites include them as standard fare.

There is no hard-and-fast rule about what constitutes a 'good' price-to-earnings ratio. However, studies suggest that over long periods (i.e., many decades) of time, the average P/E of the S&P 500 is about 15. All else equal, when stock prices go up, then the P/E increases, implying that valuations are richer or more expensive. Conversely, when stock prices go down, then the P/E declines, implying that valuations are cheaper.

Currently, the PE ratio of the S&P 500 stands at about 22.4, suggesting that stocks as a whole are generally pricey compared to long term averages. On a relative basis, JNJ's P/E calculated above appears to be in-line with the rest of the market.

Although price-to-earnings ratios can be useful, they have several drawbacks--all of them related to the estimate of 'E' in the denominator. Net income figures have often been subjected to accounting tricks that render them inaccurate measures of true cash earnings power. Moreover, analysts often report P/Es on a 'forward' basis, meaning that they use earnings estimates for the coming year rather than actual earnings from the past. This practice complicates interpretation of the metric. Finally, using earnings estimates for a single year does not capture the dynamic cash generating potential of a company over a multitude of future years (which is what you really would like to know).

Despite the warts, price to earnings ratios are good places for investors to begin their valuation analysis.

position in JNJ