P/E Methods: Looking Back vs. Looking Ahead

Question: I know there are different ways to compute the price/earnings ratio. What method does Morningstar use?

Answer: The P/E ratio is a popular metric used to assess a stock's valuation. A low P/E is often taken as a sign that the market is discounting the value of the stock's future earnings while a high P/E means its future earnings are selling at a premium. For example, a stock with a P/E ratio of 8 might be considered much cheaper--that is, a better bargain--than one with a P/E ratio of 25.

The P/E ratio is particularly useful when comparing stocks in the same industry. For example, fast-growing tech companies often have higher P/E ratios whereas utilities, which typically have fewer growth prospects, often have lower P/Es. If a stock's P/E is much lower than that of a competitor it suggests the market is less confident of the company's prospects. For some industries, however, P/E is not a good tool for deciding whether a stock is fairly valued. With REITs, for example, earnings data is considered less important than another measure called funds from operations, which excludes depreciation. 

Calculating P/E
The basic P/E formula is a simple one: Take the stock's current price and divide it by its earnings per share over a given time period (usually 12 months) and you're there. So a stock selling at $10 per share with earnings per share of $2 has a P/E of 5. The complication lies in determining what to use for the earnings portion of the calculation and in particular whether to use earnings numbers that are backward-looking or forward-looking.

Morningstar.com provides both a current P/E ratio, based on trailing 12-month earnings, and a forward-looking P/E calculation, based on analyst consensus forecasts of a company's average earnings per share during the coming 12 months. Morningstar.com readers can find P/E data for a stock by visiting the stock's Quote page and then clicking on the Valuation tab, where they will also find comparisons with the industry average, the S&P 500, and a five-year average P/E for the stock. Each of the P/E methods used on Morningstar.com has its pros and cons.

Backward-Looking P/E
Pro: Uses actual earnings data from the trailing 12-month period as opposed to potentially unreliable analyst projections.

Con: Does not anticipate factors that could affect future earnings, such as a new product launch or industry changes.

Forward-Looking P/E
Pro: May provide a more useful picture of future earnings performance that is of greater relevance to investors considering buying, selling, or holding a stock.

Con: Forecast may be inaccurate because of unforeseeable events or human error.

P/E and Equity Funds
For equity and allocation funds, Morningstar provides a weighted average P/E based on stocks in a fund's portfolio and uses a proprietary version of the metric called the equity style box factor P/E. Once an equity style box factor P/E is calculated for each stock in the fund's portfolio, it is then used, along with nine other style factors, to help determine where the fund fits within the Morningstar Style Box. (For more on the Morningstar Style Box Methodology, click here.) For example, a fund's high P/E might suggest a growth strategy, whereas a lower P/E may indicate the fund takes a value-oriented approach. The fact that the statistic is weighted means the P/Es of the fund's top holdings are going to be counted more heavily than the P/Es of smaller holdings. Fund-level P/E information may be found under the fund page's Portfolio tab, in the Style Details section. There you will also find P/E data for the fund's benchmark and category average for comparison.

Key Tool for Value Strategy
P/E is often used by value investors to identify stocks that might be selling for less than they are worth. By screening on P/E ratio and other valuation metrics, value investors--and value fund managers--can come up with a list of companies that align with their strategy: buying undervalued stocks and holding them until their prices rise. (Premium Members can use Morningstar's  Premium Stock Screener tool to search for stocks by P/E ratio, or screen on stock funds by P/E using the  Premium Fund Screener tool and selecting "Stock Valuation Statistics.")

Shiller P/E
Investors trying to determine where the market is headed also may use P/E to assess whether stocks generally are overvalued or undervalued. Among the most commonly used tools is the Shiller P/E, formulated by Yale University professor Robert Shiller. It uses average inflation-adjusted earnings over the trailing 10-year period to determine a P/E for the S&P 500, a widely used proxy for the U.S. stock market. By using 10 years' worth of earnings data in its calculation, the Shiller P/E reduces the effects of temporary swings in earnings (the denominator of the P/E formula) and focuses more attention on how the market's current price (the numerator) compares with long-term earnings trends. (A chart of Shiller's P/E calculation for the market dating back to the 19th century can be found here.) The Shiller P/E for the market currently stands at around 22, which is relatively high compared with historical readings.

Although P/E can be a useful tool in evaluating the prices of stocks, funds, and the market in general, the metric doesn't tell the whole story. Other factors beyond P/E also need to be considered. For example, when assessing a stock, you should look at company management and the outlook for the company, its industry, and the economy. Likewise, a fund manager's process, experience, and track record are important to think about when evaluating funds. What P/E does provide is an indication of what could happen to the price of an individual stock, stocks held by a fund, or the overall market based on a set of assumptions. That can be helpful, but it's far from a guarantee.

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