The price to earnings ratio, or the P/E ratio, is perhaps one of the most quoted and well-recognized valuation metrics in equity analysis. As a rule of thumb, value investors tend to seek out companies with low P/E ratios, while aggressive investors seeking growth may opt for companies with higher P/Es.
Because of the ubiquity and prominence of the P/E ratio in fundamental equity analysis, it is imperative that the budding investor is able to understand and calculate P/E ratios for any stock. This can be difficult at times given the variances in reported data and the individual nuances of a company. This article will focus on the calculation of the trailing twelve-month P/E (TTM), forward P/E and the analysis of the P/E for Google shares (GOOG, GOOGL) against comparable stocks.
In 2015 Google restructured to become Alphabet. The restructured company is now the parent of Google and several subsidiaries with sales from Google generating the majority of the firm’s revenue. Just a year prior to the restructuring Google split its stock into two share classes, GOOGL (class A) and GOOG (class C). Investors in Alphabet continue to have both as an investment choice. When analyzing the P/E ratio of the company it is important for investors to understand that the firm’s reported earnings per share take into account all of the firm’s shares across its share classes for the entire Alphabet company as a whole. Thus, both GOOG and GOOGL will have the same earnings per share value in their denominator to calculate a price to earnings ratio. (See also: How Google's Transformation to Alphabet Will Impact Shareholders and What's the Difference Between Alphabet's GOOG and GOOGL?)
Trailing Twelve-Month (TTM) P/E
The numerator of the P/E ratio is the current price of the stock (P), while the denominator (E) is the earnings-per-share or EPS. EPS is a ratio in and of itself and represents the total net income of a company on a per-share basis. It is usually calculated as follows:
Together, the price divided by the EPS makes the P/E, which reflects how much investors are willing to pay per one dollar of a company’s earnings. The price portion is easy enough - one needs to simply pull up the price of GOOG or GOOGL on any given day. Once the numerator has been attained, it is time to calculate the denominator. Fortunately, instead of calculating EPS by hand, companies are required by the SEC to report this ratio in their quarterly Form 10-Qs and annual 10-Ks. The P/E ratio like the EPS of the company will vary based on a company’s management of their outstanding shares. Thus P/E ratios will have variances when a company issues, redeems or splits shares in the market. Companies also often report GAAP EPS and adjusted EPS, so it can be important for investors to know whether comparisons are based on GAAP values or adjusted reports.
Also note, Alphabet and many companies report a basic as well as diluted EPS. A diluted EPS is generally the default value for calculating earnings per share. It takes into account all outstanding stock options, warrants, convertible stocks, and bonds that may be exercised when factoring the number of average shares. Basic EPS does not take into account any possible dilution and will lead to a higher EPS ratio.
Let’s take a look at Alphabet’s EPS in 2017/2018. In 2017/2018 Google reported the following GAAP and adjusted EPS values:
Q2 2018: adjusted $11.75, GAAP $4.54
Q1 2018: adjusted $9.93, GAAP $13.33
Q4 2017: adjusted $9.70, GAAP -$4.35
Q3 2017 adjusted $9.57, GAAP $9.57
Adding these together, we get $23.09 GAAP and adjusted $40.95. Taking the price as of October 12, 2018, and dividing by GAAP EPS and adjusted EPS we get the following:
Class A GOOGL
GAAP PE = $1,112.61 / $23.09 = 48.2
Adjusted PE = $1,112.61 / $40.95 = 27.2
Class C GOOG
GAAP PE $1,109.39 / $23.09 = 48.1
Adjusted PE $1,109.39/ $40.95 = 27.1
In these scenarios, investors are willing to pay the calculated P/E value per $1 of earnings.
While TTM P/E calculations are objective based on historical data, forward P/Es are subjective. The forward PE is calculated using the same current stock price divided by an estimate of earnings in the future. The estimated one-year future growth of earnings can be identified through several means, such as management’s guidance, historical growth rates, industry prospects and growth models based on fundamentals, such as return on capital. All these methods are beyond the scope of this article, and for the sake of brevity, many investors just use consensus data as estimated by the many analysts that already cover GOOGL and GOOG.
Morningstar uses GAAP reporting in its industry data, which as of October 12, 2018, shows the following forward P/E values.
The forward PE can be a valuable metric for basic due diligence analysis. Many analysts will use the forward PE to get a better idea of the range of P/Es for a stock. If a company’s forward P/E is rising it generally means the earnings per share are expected to increase and therefore investors would likely pay less per $1 for the earnings. If a PE is increasing, it can be a sign that the company has a change to its outstanding shares planned or that earnings per share are decreasing.
Without actually comparing a P/E with that of its peers, one cannot often get a full understanding of the ratio or make an accurate valuation assessment. Let’s compare Alphabet to some other household names in technology and internet services.
Given this comparison, all of the technology stocks have pretty high P/Es in the current market. Keep in mind, value investor Benjamin Graham suggested not investing in companies with a P/E greater than 16. The forward P/Es are also all lower suggesting that these companies are either decreasing their earnings per share or reporting increased earnings expectations.
The Bottom Line
While P/Es are useful metrics in determining the value of a stock, they are just one tool of many in fundamental analysis. P/Es should never be viewed in isolation. However, they do serve as useful foundations on which to build a deeper understanding of a company’s valuation and future prospects.