By elmads

I have discussed in my previous blog the basics of the Price-to-Earnings Ratio, its importance as a quick guide and metric to linking a company’s share price to its actual business earnings. How it can help to give a general insight whether if the company is undervalued, fairly valued or overvalued.

Nevertheless, P/E Ratio must not be the main basis to make an investment decision. It is only one of the hundredths of metrics in the investing world, its purpose is to only serve as a guide. To see Part 1 of this blog just click on the link provided. “Relative Valuation – The Price-to-Earnings Ratio Part 1”

In this part 2 blog, I’ll be further explaining other variations of The Price-to-Earnings Ratio, such as the Trailing, Forward, and PEG ratios.

The Trailing-Twelve-Month (TTM) P/E Ratio

The formula and computation is the same as the Standard P/E Ratio, the only difference is the data that we will be gathering. In the standard P/E Ratio, we automatically get the total net income of a company at the end of the full Fiscal Year, in trailing-twelve-months what we take is the 4 most recent quarterly net income of a company to arrive into the trailing-twelve-months EPS first.

Let me explain the difference between a fiscal year earnings report, half year earnings report and quarterly earnings report to make things clear as glass.

• Fiscal Year (FY) earnings report – It is the the whole year’s earnings report of a company, for example the last fiscal year of 2020. The earnings made by a company within that specific year. Most companies follow the calendar year for fiscal year (FY) reports, but not all companies and countries do this.
  
  For instance, Apple Inc’s Fiscal year ends in September of every year, while Microsoft’s Fiscal Year ends in June of each year.

• Half Year earnings report – This is the Earnings from the first 6 months, then the second 6 months.

• Quarterly earnings report – this is the earnings made by a company in a single quarter. One quarter consists of 3 months, so that is the earnings within the 3 months period.

The photograph below is a clear depiction of these three

Now that aside, to get from trailing twelve months of a company we first need the information of the company’s earnings per share for the 4 most recent quarterly reports.

As an example, we will be using Amazon’s quarterly repots. See below chart.

https://ir.aboutamazon.com/quarterly-results/default.aspx -This is the link for Amazon’s financial statement reports. This is where I got the information for the above chart.

Just like what I did above, we need to get all the 4 most recent quarterly reports, then get each data of net income and diluted shares outstanding.

Divide the net income to the shares outstanding in order to get the EPS of a company per quarter. Afterwards, add the 4 most recent Earnings-Per-Share (EPS) to arrive into the nearly real time updated EPS, or commonly known as Trailing-Twelve-Months (TTM) EPS.

Subsequently, Divide the current share price of Amazon to its Trailing-Twelve-Months (TTM) Earnings-Per-Share (EPS).

• (TTM) P/E Ratio = 3,478.48 per share / $52.55

• (TTM) P/E Ratio = 66.19

Now that we have the TTM P/E Ratio, it is up to us now to give meaning on this result. Again, just to remind us, this is only one of the indicators to consider when making an investment decision. We do not decide purely based on P/E Ratios.

Note: We can still use the chart metric, comparative by industry and historical P/E ratio methods, which I discussed on the Part 1 of this blog. With this Trailing-Twelve-Months (TTM), we can also do this in tandem with the (TTM) comparative industry.

Then again, another problem arises with both Fiscal Year (FY) type of P/E Ratio and the TTM P/E Ratios. Both of them are based from past data to most recent past data.

The Forward P/E Ratio

It is well known in the investing world that past data and earnings doesn’t reflect the future earnings of a company. It doesn’t mean that they did bad these couple of years, that they will continue to have poor earnings in the next few years, and the opposite scenario is true as well.

In here, we get the 2 most recent quarterly earnings and look for their EPS, then we add the projected EPS in the next 2 quarters of the company. Or, another variation is to look for the complete projected EPS for the next 12 months, and use it.

Companies always have their own projections of their business earnings in the upcoming months and quarters. Furthermore, there are equity analyst estimates as well, which they publicly disclose.

NOTE: Equity analyst, also known as equity research analysts, provide financial guidance and expert knowledge of stocks and bonds to investment advisors, brokers, and individual investors. This role combines data gathering and assessment with financial modelling and forecasting to make informed decisions about investment opportunities and risks on the buy side, sell side, or both

So that’s what most investors utilize, either by the own company’s forecast, or analyst projected estimates, or mix of both, or make our own estimates, which are all for the purpose into making an approximation of the company’s future EPS.

As an example I’ll be using the forecasted next 12 months EPS of Amazon based from analyst estimates.

Add all estimated projected EPS, as per the example above the forecasted total EPS is $56.06.

To come up with the Forward P/E Ratio, I took the current stock price of Amazon which is 3,478.48/share (during the date of this writing) and divided it to the projected EPS of $56.06, which gave me a forward P/E Ratio of 62.05

There’s a downside in doing this type of P/E ratio and that is the large margin of error with forecasted numbers. Either, the company’s estimates are too high, or the analysts estimate are to low. Then again, all estimations need to be taken with a grain of salt, that’s why it is called projection and estimation.

Note: Same as the Trailing P/E Ratio, we can also use the Forward P/E Ratio with comparative by industry and historical P/E ratio methods as long as we use the forward P/E ratios.

Summary of P/E Ratios based on the data of earnings taken.

The Price-to-Earnings-to-Growth (PEG) Ratio

Investors thought that the Forward Price-to-Earnings Ratio, do not suggest if the company’s growth Earnings Per Share forecast by equity analysts, are appropriate with the ratio. That’s why PEG ratio has been formed, it is by using the Trailing PE of the company (which is a lagging P/E indicator, but the most up to date unlike to the Standard P/E Ratio), and the growth of the company’s EPS.

To make it understandable, I’ll be using Amazon.com and eBay Inc. as an example. Data taken from their most recent 4 quarterly reports (during this time of writing).

Amazon. com

Trailing P/E Ratio : 66

EPS Growth from FY 2019 to 2020 : 81%

EPS Growth computed as follows (Current EPS – Previous EPS) / Previous EPS

EPS Growth = (42.66 – 23.46) / 23.46

  = 19.2 / 23.46

  = 0.8184

  = 0.8184 * 100 (to make it into a percentage)

  = 81.84%

Amazon PEG Ratio = Trailing PE Ratio / EPS Growth

  = 66 / 81.84%

 Amazon PEG Ratio = 81.48

eBay Inc.

Trailing P/E Ratio : 16

EPS Growth from FY 2019 to 2020 : 100%

EPS Growth computed as follows (Current EPS – Previous EPS) / Previous EPS

EPS Growth = (3.54 – 1.77) / 1.77

  = 1.77 / 1.77

  = 1.00

  = 1.00 * 100 (to make it into a percentage)

  = 100%

eBay PEG Ratio = Trailing PE Ratio / EPS Growth

  = 16 / 100 %

 eBay PEG Ratio = 16

What does PEG Ratio says?

If you look at a specific company’s PEG ratio without comparing it to other companies or companies within the same industry. Then, PEG Ratio of 1 should denote that the company’s P/E Ratio and expected growth of its earnings is fairly valued.

If it exceeds more than 1 then that is overvalued, either the PE Ratio of the company is to high or the expected growth is just slow, or vice versa.

On the other hand, when the PEG ratio is less than 1, then that is considered undervalued relative to its PE ratio and projected growth

See table below

Nevertheless, the average PEG Ratio same as P/E ratio will depend in every industry. See for example Oil & Gas companies, their PEG ratio average for the whole industry is hovering from below 1 to exactly 1. This is because Oil and Gas is already a mature industry, investors do not expect a massive and exponential growth for this industry anymore. Whereas, technological companies are seen as in the early phase of its life, their growth expectations are commonly high, that is why the metrics such as P/E and most especially PEG are sky high. Just like in our example of Amazon & eBay.

Amazon PEG Ratio = 81

eBay PEG Ratio = 16

If you look at it at individual company PEG, then definitely they are way way overvalued because both are greater than a PEG of 1. Other investors approach this on the industry’s Average PEG ratio. This is the same as the P/E Ratio of comparing a single company to the industry’s average PE. The only difference is that in here, we need to compute each of the company’s PEG ratio that is within the same industry, then average all of their PEG ratio. If the PEG ratio, let’s say of eBay is lower than the average PEG of the industry then we could surmise that eBay is undervalued, so on and so forth.

By comparing the two PEG ratios, we could say that eBay is cheaper than Amazon considering that it is just at 16, whereas Amazon is at 81 PEG ratio.

Basically what we did is the PEG Ratio by comparing companies within the same industry.

The Earnings-to-Price Yield (Earnings Yield)

This is actually the same as the PE Ratio but we just interchanged the numerator and the denominator for the computation.

Earnings Yield Formula: Company’s Earnings Per Share / Company’s Share Market Price

I’ll be using Apple Inc as an example.

• Apple Inc 202 EPS: $3.28
• Apple Stock price as of 2/06/2021: 133.70
• Apple’s Earnings Yield: $3.28 / $133.70 per share
• Apple’s Earnings Yield: 2.45%

What does earnings yield entail?

This method doesn’t focus on, if a company’s share price relative to its earnings is undervalued, fairly valued or overvalued. Instead, it looks into how much will our money return to us if we have invested our money to this company. For instance, with the previous Apple Inc earnings yield example. If I invested money with apple now then I expect roughly only a return of 2.45% for a year, that is including the dividends and potential price appreciation.

This method is rarely used by investors, but there are some who do use it, like the dividend investors. Remember, dividend investors usually look for what returns they can get from the company’s dividends, or the whole return in a stock both dividends and the potential price appreciation.

Earnings yield and Price-to-Earnings are reversely correlated. When one is high the other one is low, and vice versa.

To sum it up

I will always keep on repeating, reminding and emphasizing this, that Price-to-Earnings ratio is only a guide to support our investment thesis, it is not the sole metric that will dictate if a company is undervalued, fairly valued and overvalued, and most of all not the signal to use if it is a buy, hold or sell. It is only one of the hundredths of metrics in making our investment research and thesis.

Furthermore, PE Ratios have a lot of loop holes,

1.) It is backward looking, it will always be a lagging indicator of a company’s earnings.

2.) No forecast is guaranteed, not even analysts forecast.

3.) Market Prices most of the time is dislocated to company earnings

4.) Company’s cash flows, investments, reinvestments, decisions and competitive advantage dictate its growth and valuations, not its stock price.

This concludes the two part blog of my Price-to-Earnings Ratio relative valuation. If you have not read the 1^st part of this blog, then click the link provided below.

“Relative Valuation – The Price-to-Earnings Ratio Part 1”

Knowledge is my Sword and Patience is my Shield,

elmads

This blog is for informational purposes only and not a Financial Recommendation. Not all information will be accurate. Consult an independent financial professional before making any major financial decisions.