Monday, April 8, 2013

Stock Valuation Method - Average P/E Ratio

In an attempt to determine the fair value or a target entry price for a stock, it's best to use multiple methods to compare across different metrics.  This is the 3rd part in my series on stock valuation methods in which I've already covered the Graham Number and the Average Dividend Yield.  Today I'm going to take a closer look at the average low P/E ratio method.  This one is very similar to the average dividend yield valuation.

If you recall from my post on the Graham Number, I prefer to use the fully diluted earnings that are only from operations of the company.  Earnings per share can be altered by one time sales of plants or equipment.  These one time items won't continue to contribute to the earnings of the company and that's why I prefer to exclude these from the earnings per share number.

To calculate the average P/E ratio you go through the same process as in the average dividend yield method and obtain data for the earnings per share for the last 5 or 10 years.  I prefer to get 10 years so that I can have two metrics to compare to, a 5 and 10 year average.  Since we've already gotten the data for the high and low price points during each fiscal year the rest is pretty easy.

Now you take the high price for each year and divide that by the corresponding earnings per share.  This will give you the high P/E ratio level for each year.  Then repeat the process using the low price for each year and dividing that by the earnings per share for each corresponding year.  You now have the high and low P/E ratio for each year and then average the last 5 years and then 10 years of low P/E ratio and high P/E ratios.

To determine a target entry price you can then take your own projected earnings per share or use the analyst projections.  Keep in mind though that the analysts aren't anywhere close to 100% right so take their estimates with a grain of salt.  However, they usually know the company better and have access to more information that you or I, so I use the analyst estimates.  Once you have the earnings per share value you're going to use, multiply it by the 5 and 10 year low and high P/E ratio averages that you've already calculated.  The low P/E ratio averages will provide a low valuation price point while the high P/E ratios will give a high valuation price point.

Now compare the current price to the low P/E ratio price points to determine whether the shares are currently trading at a discount to its historical ratios.  As they say, past results are no guarantee of the future, but it's a great starting point.  You now have three different valuation methods in your arsenal and next week we'll take a look at another metric.


4 comments:

  1. Hey Passive Income Pursuit! This is similar to a method I recently started using to get a quick idea of valuation before digging in deeper to analyze a company. I've been taking the 10 year average P/E ratios and comparing to current P/E. Lower current P/E would be fair or undervalued where as higher current P/E may indicate an overvalued stock. Of course I then think it is important to really dig into the numbers before making a final purchase decision.

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    1. Dan Mac,

      It's a good quick way to determine whether it's trading at a historically undervalued price. But as you mention there's much more to look at to determine whether the company is a buy or not. The historic PE ratios don't have any meaning on the ratios that it will trade for in the future so you could easily see PE expansion or contraction.

      Thanks for stopping by!

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  2. As Dan pointed out this is a good way to get a general idea/feel for how a stock trades over time. I have recently started using this in my analysis and it has helped me leaps and bounds.

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    1. Marvin,

      Every valuation method is just a guess because no one knows what the future will bring until someone can create a time machine. Most of these historical trend techniques are much more suited to large cap consumer staple companies because their earnings should be less volatile. A small or mid cap company in a fast growth phase isn't going to really jive with the historical basis because so much is changing with the company and a lot of investors will push the price to unwarranted valuations.

      Thanks for stopping by!

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