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The price-to-earnings ratio is the most widely used multiple in the world. Pricing is much more common than valuing. In the DCF model you have to make assumptions about growth, cash flows and risk, in pricing it requires fewer assumptions and its the simplest form of this approach.
The P/E Ratio is difficult to use when comparing companies across industries. This is because different industries are evolving and making money in different ways and can have different P/E ratios.
If we compute the P/E ratio for 15 other companies and the P/E ratio of your company is 10 and ratio for this sector is 15, we say that stock is cheaper. We are assuming that the other companies are fairly priced in the industry and because of that your company is underpriced. We assume that all firms within a sector have similar growth rates, cash flow and risk, a strategy of picking the lowest P/E ratio stock in each sector will yield undervalued stocks. Cheap stocks are often cheap for a reason. Thus, we are making implicit assumptions about the companies.
This is the most common approach of estimating the P/E ratio for a firm but there are problems with this approach. Firms in the same industry can have different risk, growth prospects and profit margins. So if the stock looks cheap, it deserves to be cheap.
Analysts sometimes compare PE ratios to the expected growth rate to identify:
Firms with PE ratios less than their expected growth rate are viewed as undervalued;
Firms with PE ratios more than their expected growth rate are viewed as overvalued.
Another note to take is that bullish analysts like to use forward numbers (1) because it makes the P/E ratio multiple look lower. Bearish analysts always like to use trailing numbers (2) because it makes their stocks overpriced. In its more general form, the P/E ratio to growth is used as a measure of relative value.
Forward P/E forecasts projected future earnings of a stock.
Trailing P/E measures the earnings per share of a stock for the previous 12 months.
The biggest problem with the P/E ratio is that it doesn’t take growth into account but it is affected by the growth. So it doesn’t tell you much about the company’s ability to grow revenues and earnings in the future.
There’s three variables that drives P/E ratio for a stable growth dividend paying company:
First, payout ratio the % of earnings pay out as dividends;
Second, cost of equity reflective of the risk of the stock;
Third, expected growth rate.
You have to put in control for differences in growths and earnings, cost of equity and payout ratios.
"In its simple form, there is no basis for believing that a firm is undervalued just because it has a PE ratio less than expected growth. This relationship may be consistent with a fairly valued or even an overvalued firm, if interest rates are high, or if a firm is high risk."
Some of the best performing stocks have had very high P/E ratios, such as Google or Amazon.
By looking at the diagram below, Russian stocks look incredibly cheap. What we are actually missing here is that we have to consider the different ERPs between the countries and different controlling risk factors. Riskier countries will have low P/E ratios but we have to bring real difference variables such as country risk, growth (high growth economies should have higher P/E ratios) and interest rates (high interest rate, low P/E ratio).
Emerging Markets, March 2014 (pre-Ukraine)
Source: Aswath Damodaran lectures
P/E ratio should not be used to determine whether a stock is worth buying. However, there is no single metric that can predict whether a stock is a good or bad investment but relative valuation should be used in conjunction with other tools such as a Discounted Cash Flow which takes its key factors in terms of cash flows, growth and risk and research about the company’s financial statements to get a good picture of a company’s value and performance.
If you are interested in reading more about P/E ratios, check out Aswath Damodaran's blog posts here: