How does the Price-to-Earnings (P/E) ratio help you evaluate whether a company is worth becoming part of your investment portfolio? Let’s explore this in this article.
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The Relationship Between a Stock’s Price and its Earnings
One of the benefits of entering into a bear market territory is seeing stock prices for some companies adjust in reaction to market conditions. That in turn offers the contrarian investor unexpected opportunities to acquire stock in companies with a P/E that may make more sense than during a bull market.
First Quarter 2022 Earnings Exceeded Expectations
The earnings scorecard for the first quarter of 2022 is complete and the profit picture looked pretty good. According to FactSet, 77% of companies in the S&P500 reported earnings per share (EPS) that exceeded Wall Street estimates. S&P500 earnings rose 9.2% year-over-year.
This increase was much better than what analysts thought at the beginning of March when expectations called for 4.6% earnings growth.
Stock prices are a function of earnings times a “multiple”.
Collapsing Price-to-Earnings Ratio
While earnings increased, the S&P500 index nevertheless is down about 12.5% from the end of 2021. This is the result of a collapse in the price-to-earnings ratio (P/E), the multiple. The forward 12-month P/E of the S&P500 on January 1st, per FactSet, was approximately 21. It is now 17.
What is a P/E Ratio?
The P/E ratio is a reflection of how investors value a company or index. The value is an estimate of the future stream of income and some end value for a company, either the result of a takeover or liquidation.
For example, S&P500 estimated earnings for next year is about $245. Multiply this by 17 and you get the current price of the S&P500 index.
The same calculation applies to individual stocks. The P/E is what investors are willing to pay above the expected level of profits. The P/E is influenced by interest rates and sentiment.
Rising Interest Rates Depress the Price-to-Earnings Ratio
In 2022 we have seen interest rates rise which, other things being equal, depresses the P/E. We have also seen a sharp decline in investor sentiment as worries about a recession (a decline in profits) and geopolitics took center stage. Investors are cautious and not willing to pay much for future profits.
Historically, we are below the 5-year average forward S&P500 P/E of 18.6. We are just about at the 10-year average of 16.9. It is impossible to know precisely what the “correct” P/E should be.
Does a P/E of 17 discount, sufficiently, the future level of recession, inflation, and interest rates? If the factors that depressed P/Es – interest rates, sentiment – do not stabilize or reverse, it will be up to company profits to move the stock market higher or at least keep prices stable.
P/Es as Discounting or Premium Function for Investors
Following the above discussion, P/Es represent the “discounting” or “premium” function for investors. In times of euphoria, investors bid up stocks, putting a premium on company prospects. In times of pessimism, investors sell off shares and discount perceived bad news.
The Stories of Individual Stock Price-to-Earnings Ratios
Above, we looked at the S&P500 index but there are interesting stories within individual stocks.
The collapse in P/E ratios for some stocks is dramatic. In many cases, this is appropriate however in others, the decline in P/E may be “over-discounting” the problems investors anticipate on the horizon.
These are the times when nimble investors who do their homework can find bargains. The sentiment pendulum swings too far in both euphoric times and in negative times.
With respect to fallen tech and e-commerce names, investors need to look at whether the company’s business is broken and permanently impaired and thus deserves a dramatic mark-down in P/E or whether there is a real business there and that any decline in profits or reduction of company guidance is just temporary and the respective P/E is way too low.
P/E Example: Lennar (LEN)
To illustrate (these are NOT recommendations) how to look at P/Es in the investment decision process, let’s look at Lennar (LEN), one of the largest home builders.
With rates rising and home prices high, home affordability is an issue. Expectations for home builders have dropped substantially. LEN is now $81 per share down from a high of $117. The P/E has fallen from 8.9 to 4.8.
Does a 30% drop in price and a 45% decline in P/E already discount the challenges LEN may face?
P/E Example: Netflix (NFLX)
A more dramatic example is Netflix (NFLX).
On November 17, 2021, NFLX traded at $691 per share and had a forward P/E of 64.5. Today, NFLX trades at $199 and has a forward P/E of 18.2.
These are declines of just over 70%.
Is the NFLX business model permanently challenged by streaming competition?
Does an 18.2 multiple accurately reflect future growth in a post-pandemic world?
If overly pessimistic, then NFLX may be a bargain. If not, the shares may be fairly priced or possibly still over-valued at a price 70% lower than it was less than a year ago. Warren Buffett is attributed to have said,
“Any asset at the right price.”
How Do You Evaluate the Price-to-Earnings Ratio of a Company?
The P/E ratio is a tool to figure out the “right” price or at least if low enough, gives some “margin of safety” if you are wrong. Are you using it as such?
What other information do you use to add context to the P/E ratio? Please don’t hesitate to reach out with questions.
Thanks for reading!
Note: This blog article is intended for general informational purposes only. Nothing in it should be construed as, and may not be used in connection with, an offer to sell, or a solicitation of an offer to buy or hold, an interest in any security or investment product. Investing involves risk.