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. Benjamin Graham in Security Analysis prescribes a P/E of less than 16 for defensive investors, while aggressive investors seeking growth may accept companies with higher P/Es. Because of its ubiquity and prominence in fundamental equity analysis, it is imperative that the budding investor is able to understand and calculate P/E ratios for any stock. 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 in regards to Apple Inc. (AAPL) and its competitors.
Trailing Twelve-Month (TTM) P/E
The numerator of the 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 how much monetary value the net income of a company has reflected on a per-share basis. It is usually calculated as follows:
(net income – preferred dividends) / weighted average number of outstanding shares = EPS.
Together, the price divided by the EPS ratio makes the P/E, which is a multiples ratio that also 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 Apple’s price 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.
When considering earnings per share there can be several caveats to note. Companies often adjust their outstanding shares through new share issuance, buybacks and stock splits. This activity will affect the earnings per share growth and the PE ratio. Companies calculate earnings per share on an adjusted basis and a GAAP basis. The adjusted values are often the strongest and are generally reported by the media. GAAP values are often used by data providers so it can be important to understand both. Also, companies report basic and diluted earnings. Diluted earnings are typically the default for earning per share calculations and represent all of the shares of a company including convertible shares, all outstanding stock options, warrants, and convertible stocks and bonds that may be exercised when factoring the number of average shares.
Now, let’s take a look at Apple’s adjusted/reported EPS for the last four quarters in 2018.
Summing these up we get $11.03, and taking AAPL’s price on Oct. 12, 2018, of $218.98, dividing it by EPS ($218.98 / 11.03), we get a PE of 19. This shows that the stock’s value is 19 times its earnings per share and that investors are willing to pay $19 for every $1 of Apple’s earnings.
While TTM P/E calculations are objective measures based on historical data, forward P/Es are subjective calculations as they take into account a company’s projected earnings growth. The growth rate can be inferred 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, we will use the consensus growth rates as estimated by the many analysts that already cover AAPL.
Using the forward PE in conjunction with the TTM PE is often the most valuable analysis for understanding a firm’s PE metrics. Morningstar assigns a forward PE of 16 to Apple which gives it expected earnings per share of $13.68. Keep in mind the forward PE also uses the current stock price in its calculation. Yahoo Finance suggests a bullish estimate for 2018 earnings per share of 12.5, resulting in a forward PE of 17.52.
To identify the one-year future growth prospects of a company many investors will compare the TTM PE to the forward PE and also use a company’s historical annual PE through different time periods. This helps to identify a range which can be used as a multiple for future projections.
In this case, the range would be 19 (TTM) to 16 (forward). This indicates that the price could drop, earnings are increasing, the company has announced a shares outstanding change or any combination of these scenarios. Regardless, the forward PE indicates that investors will be willing to pay less for $1 of earnings in the future all things equal.
In this case, 12-month earnings per share are expected to increase, going from 11.03 to 13.68. If the stock maintains its 19 PE, then its one-year price could potentially be $270.86. Overall since the TTM and forward PE change with the changing denominator but use the same numerator, the PE value analysis centers around the calculated and estimated earnings per share. Generally, this analysis can also hold true for all types of forward-looking ratios including ratios such as P/B or P/S. The ratio provides the value the market is willing to pay per $1 in book value or sales.
Institutional investors with greater access to market data will often do a more thorough analysis of a stock’s ratios looking at historical levels per year over the past five or 10 years. A five- or 10-year annualized average of Apple’s PE would provide an even greater scope for analyzing the value per earnings dollar that investors are willing to pay.
Comparing a PE to its peers is also important for understanding how the market is pricing the stock. Below we look at Apple’s PE and forward PE in comparison to the FAANG stock group.
Here we see that Netflix has the highest PE, thus investors are willing to pay the highest value per $1 of earnings. The forward PE levels show that all of these companies could be expecting an increase in earnings per share causing the forward PE to decrease. Based on Benjamin Graham's analysis, all of these companies all would generally be outside the scope of a value investor’s picks with the PEs all above 16. From a market technical perspective, however, Apple could have more room to run since its TTM PE is the lowest of the list.
The Bottom Line
The P/E may create more questions than answers and serves as one metric for investment due diligence. Ultimately, the investor must ask whether or not they are getting value in a company as opposed to getting a cheap product that has been discounted for a reason. Because of this, the P/E should never be the only valuation metric in gauging in a company’s worth. However, PE analysis can serve as a useful foundation on which to build a deeper understanding of a company’s current and expected value.