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Read thoughts from Laura Berkowitz, Ed Champi or Ralph Seger about this topic.
More from Ralph Seger.

Evaluating Past P/E Ratios

What is a P/E Ratio?

The simple definition is price divided by earnings.

The P/E ratio answers the question: "What are investors willing to pay for a dollar of this company's earnings?"

The price is a definite number, but has the potential to change with every trade so the P/E can also change with every trade.

Earnings is a totally different animal.

Data comes in different flavors.

• Standard & Poor reports data as reported, but adjusted to standard fields.
• Value Line reports normalized data, data adjusted for non recurring events.
• Annual reports present raw data.                                                     
• OPS is S&P data with normalized adjustments.

Pick one source and stick with that source. Don't mix data sources.

NAIC's P/E traditionally uses the latest four quarters of earnings. Earnings would change every quarter.

NAIC's Projected P/E uses the forecast next four quarters of earnings. This too would likely change every quarter.

The P/E assigned to a company has intrinsic and extrinsic components.

Intrinsic components are items management has control over such as rate and consistency of growth of sales, EPS, and dividends, proper use of debt, liquidity ratios, profitability ratios, etc.

Management that does an excellent job of running a company may command a higher P/E than a similar company with less stellar results in these areas.

You may also wish to consider where in the lifecycle of a company this stock is. If the rate of sales and EPS growth are slowing, the P/E of a maturing company will usually decrease.

Extrinsic factor are beyond the immediate control of management and include such items as inflation, interest rates, war, terrorism, etc.

In addition to these basic factors, our basic human emotions of fear and greed may cause an over rated or under rated response to any of these intrinsic or extrinsic factors.

Kaush Meisheri has an excellent series of articles on the factors that influence a company's P/E. Click here to view his second article that deals with P/E and click here to view his third article that also deals with P/E.

Why not read his first article too? Click Here.

What is Relative Value?

Relative Value is simply the current P/E divided by the five year historical P/E.

Projected Relative Value is simply the projected P/E divided by the five year historical P/E.

If P/E answers the question: "What are investors willing to pay for a dollar of this company's earnings?", then relative value answers the question: "Are investor's willing to pay more or less for a dollar of  company's earning than they have been in the past?"

BetterInvesting uses this as one of the four test for a stock having a fair price.

Ellis Traub considers it to only be an indicator of emotion in the stock and uses it to issue a "Hot" or "Cold" investor sentiment in his original version of the computer program, Take stock.

Two factors affect how a price can go up. Either the EPS, or the P/E, or both have to increase.

Pat Dorsey, in his book, The Five Rules to Successful Stock Investing, refers to EPS growth as investment return and P/E expansion as speculation return.

Since we hope to own a growth stock we'll assume the EPS will be higher in 5 years. If the EPS grows at a rate of 10%, we'd expect an investment return of 10%.

Relative Value gives us an idea whether we should expect speculative return or not.

When the current P/E is Equal to the five year average P/E, the Relative Value is 1 or 100%.

When the current P/E is above the five year average P/E, the Relative Value is over 1 or 100%. e.g. 130%

When the current P/E is below the five year average P/E, the Relative Value is below 1 or 100%. e.g. 85% or 40%

If we purchase the stock when the Relative Value is 100% we would expect no speculative return . We would expect our stock's price to increase at the rate of 10% from the EPS growth's investment return.

If we can purchase a stock when the Relative Value is below 100% we increase the chances we will also receive some speculative return. In other words, we might expect our stock's price to increase more that the 10% from the EPS growth's investment return.

If we can purchase a stock when the Relative Value is above 100% we increase the chances we will also receive some NEGATIVE speculative return. In other words, we might expect our stock's price to increase more SLOWLY that the 10% from the EPS growth's investment return. We might see the price increase at only 7%.

BetterInvesting recommends you purchase stocks with Relative Values between 85% to 110% to take advantage of positive speculative risk and minimize negative speculative risk.

Situations where the Relative Value are significantly below 85% are an alert that the market may know something you are not yet aware of. You'd need to investigate the company for bad news.

Situations where the Relative Value exceeds 110% indicate a stock which is overvalued. Investors are willing to pay mush more for a dollar of the company's earning than they have in the past. The higher it goes, the more over valued the stock becomes. And, if you were to purchase it at this Relative Value, the better chance you would have negative speculative return and a price growing slower than the EPS rate of growth.

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