If you invest the way recommended by The Small Investor – buying into great companies and holding them indefinitely – you can use price earnings ratio, or “PE,” to predict future prices for your stocks. In this article we’ll go into what PE is and how you can use it when evaluating potential stocks to add to your portfolio.
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What is PE?
Price earnings ratio is just what it sounds like, the share price of a stock divided by its earnings per share. (It is also equal to the market cap, which is the total number of shares times its share price, divided by total yearly earnings.) It is used to judge how expensive a company is. If a stock has a high PE, meaning a high price is paid per dollar of earnings, it is more expensive than one that can be bought for a lower price per dollar of earnings. For example, if XYZ Corporation cost $100 per share and ABC Corporation cost cost $25 per share and both had earnings of $1 per share, XYZ would be way more expensive than ABC. Their PEs would be 100 and 25, respectively.
Does that mean you should buy ABC because it is cheaper? Not necessarily. It might be that XYZ is expected to see earnings increase to $10 per share this year, while ABC will see earnings grow to $2 at most. This means that even though XYZ is more expensive, there are things about the company that make it worth the higher price. This is why people are paying more for it.
Share price is easy to determine, but what about earnings? Which earnings do you use when calculating PE? The answer is that different earnings numbers are used. Sometimes the price is divided by the last year’s earnings. This is called the “trailing PE ratio.” Often the PE is calculated using predicted PE ratio. Sometimes the average of past and future earnings is used. The most important thing is to make sure you’re using PE ratios calculated the same way when using PE ratio for predictions or stock value assessments.
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Using PE to evaluate stock prices
If you look at the PE for a particular stock, you’ll find that it tends to be within a certain range. For example, maybe XYZ corporation has a PE that ranges between 10 and 15. You can use this to evaluate how pricey a stock is and compare the relative expensiveness of different stocks. You can then choose to buy less expensive stocks, theoretically getting a better price when you buy stocks this way. You can also use this technique to decide which stocks to sell when you need to raise cash for something.
To use PE ratios to evaluate how pricey a stock is at a given time, you’ll need to find a source that provides the PE ratio for a number of years. Value Line Investment Survey provides this info. If you have earnings history and share price history (from Yahoo finance, for example), you can calculate the historical values yourself using the high and low prices for the stock for the year along with the average earnings during the year. You can often get historic stock earnings from the company’s website (maybe going through old annual reports) and some other sources. Your brokerage may also provide this info.
Once you have a range of historic PE ratios, you can simply look at the current PE and see how it compares to the historic range. For example, if XYZ had a PE of 20 right now, that would be high compared to the historic range of 10 to 15. This might mean that the stock was overpriced and you should wait to get in or buy a different stock that was cheaper. It could also mean that the stock is about to see earnings grow faster, so people are willing to pay more. PE is just one factor to evaluate when picking which stock to buy. You need to dig further and try to figure out why the PE ratio is high or low.
That said, people certainly bid up stocks to high prices, higher than they should be given earnings, or sell them off until they are dirt cheap. Just because a PE is high doesn’t mean that the stock will fall in price soon. Still, you can take advantage of this behavior to get better prices for stocks when you buy and sell. For example, maybe you like XYZ corporation, but it is trading at a PE of 30, way above its normal range. You might wait for people to get worried about the price and sell some shares, driving the price back down, before taking up a position in the stock. (Yield, which is the dividend divided by the share price, is another way to evaluate stocks if they pay a dividend.)
Using PE ratio when deciding which of several stocks to buy at a given time is a valid method. In fact, this is better than sitting on the sidelines with cash, waiting for a given stock to become cheaper, since you don’t want to be out of the markets when big rises happen. It is better to be invested in something that is cheaper now.
To start, gather a list of stocks you are interested in buying into to build a portfolio. This is your “watch list.” Then use PE ratio to help which stock to buy more of each time you have money to invest. If a stock you are interested in does not yet have positive earnings, or they are going through a rough time when earnings are negative but you expect them to improve with time, you can also use price to sales ratio (PS), which is the price divided by the sales per share, the same way you can use PE.
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Predicting prices using PE
OK, so how do you predict prices using PE? The answer once again involves the historic range of PE for the stock. Stocks tend to trade within a given PE most of the time. This makes sense because people tend to assign a value to things, including stocks. If the price is high compared to that value, they tend not to buy. If it is low, they think it is “cheap” and will rush in to buy.
This behavior of trading within a PE range means that if you have a way to predict future earnings, you can use the PE range to predict what the stock price will likely be. This works best if you predict at least a few years into the future, rather than trying to predict the price within a year or two, since longer periods are less affected by people’s emotions. Manias that drive prices high and fear that drives prices low usually average out if you give things enough time. The PE ratio range will be where the stock is most of the time, but not all of the time.
For example, let’s say that XYZ Corporation has earnings growing at 10% per year and currently has earnings of $1 per share. At 10% per year, using the rule-of-72, you can predict that earnings will double every 7.2 years:
72 years/10% = 7.2 years
If we want to predict the range of probable prices for XYZ in 6-8 years, we look and see that historically XYZ has traded with a PE ratio between 10 and 15. This means that if earnings are $2 per share in 6-8 years, the stock should be priced between $2 x 10 = $20 and $2 x 15 = $30 dollars per share at that time. If the stock is currently priced at $15 per share, we’ll make between a $5 and $15 profit per share over that period. If we have $15,000 invested now, we’ll then have between $20,000 and $30,000 at that point.
You can use this information when deciding if a stock is worth buying or choosing among different options. Of course, if the business of XYZ falls into a rough patch and doesn’t see earnings double, the stock price will probably not grow this much. If it starts to grow more rapidly, the stock price might be even higher.
The more predictable the earnings are for a company, the better these predictions will be. But stocks that have predictable earnings will also tend to have lower returns. This is because people will bid up the price and reduce the possible future gain to the minimum level they want to receive. If a stock has less predictable earnings, people will pay less for the stock because they will want to be compensated for the chance that the predicted future earnings will not occur.
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Of course, things going on in the economy and with the markets will have an effect on future prices. If the Federal Reserve starts raising interest rates in 6 years, it might drive the price of all stocks down, including the stock you’re making predictions for. Another major event that scares investors might also cause prices of basically everything to fall. You need to realize these are just loose predictions and there is uncertainty involved. It is not like estimating the future value of a bank CD. But that is what makes the returns for stocks higher than they are for CDs.
Events will play out, however, and things will eventually reverse if things are bad in the future period for which you make your prediction. When they do, your stocks will usually move back within their normal range of PE ratio. If there is a big bear market in 6 years, maybe your stock will be priced below your predictions. But if you wait another year or two, things may change and your predictions may be better.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.
