Right now the stock market is in the midst of a quarterly event known as earnings season. Four times each year corporations issue reports on their earnings for the prior quarter.  These numbers can play a significant role in market volatility depending on whether the earnings exceed or fall short of the estimates of stock analysts.

Most of the tools we use to assess the condition of the overall market or of an individual investment are technical or cyclical. Measuring investments on the basis of earnings is considered fundamental investing.

In a perfect world, the exact value of a stock could be determined by its earnings. Unfortunately, neither the world nor the stock market is perfect so stock valuations can fluctuate widely no matter their actual or projected earnings.

One of the more common methods of determining stock valuations is called the price-to-earnings ratio (P/E ratio). It is also called the earnings multiple. According to Wikipedia, the P/E ratio “is a measure of the price paid for a share relative to the annual net income or profit earned by the firm per share.”

In simple terms a higher P/E ratio means that investors are paying more for each unit of net income. That means a stock with a high P/E ratio is more expensive when compared to one with lower P/E ratio.

Traders and investors sometimes use P/E ratios as a gauge to measure whether an investment or an index is over or undervalued. There are, however, several different methods for determining P/E ratios. So when using the P/E ratio as a measurement tool it is important to verify that the same formula is being used.

The standard formula is quite simple:

Price per share divided by annual earnings per share.

It becomes more complicated because there are several methods a company can use to define earnings.

The most common is a trailing P/E ratio. That means a company calculates its net income for the most recent 12 month period, divided by number of shares outstanding.

Sometimes instead of net earnings a company will calculate its P/E ratio using operating earnings. Operating earnings exclude earnings from discontinued operations, extraordinary items such as windfalls, write downs, or accounting changes.

Other companies use a forward or estimated P/E ratio. In this instance instead of using net earnings, the company uses projected 12-month earnings. Of course the average investor has no means to determine whether or not the company’s earnings forecast is accurate.

Other variations on the standard trailing and forward P/E ratios are common. For example, sometimes companies apply techniques to P/E measures such as rolling averages over longer periods of time to smooth volatile earnings.

Obviously all of this means that if an investor is using the P/E ratio as a method of valuing a specific investment, he needs to make sure he knows the methodology used to calculate that ratio.

Interpreting P/E ratios

In general, corporations want to have as low a P/E ratio as possible because it makes their stock appear more valuable. The simplest way to interpret P/E ratios is that the ratio number reflects the number of years that it might take an investor to recoup the price paid for the stock.

Again quoting Wikipedia, “The average U.S. equity P/E ratio from 1900 to 2005 is 14 (or 16, depending on whether the geometric mean or the arithmetic mean, respectively, is used to average). An oversimplified interpretation would conclude that it takes about 14 years of earnings to recoup the price paid for a stock [not including any additional income from the reinvestment of those earnings].”

Of course stock prices can change rapidly and so can company earnings. So it is possible for a company to have a high P/E ratio one quarter and a much lower number in following quarters. For example, according to Standard and Poors, the P/E ratio of the S&P 500 Index was 122.41 for the second quarter of 2009. In the third quarter, the ratio fell to 84.30. By the fourth quarter of 2009, the ratio dropped to 21.88 as earnings of the companies included in the index rose.

There is a whole category of investing called “value investing.” The premise is that by purchasing stocks that are undervalued, there is a high likelihood that investors will bid up the price of the stock at some point and raise its value to an average or higher valuation. Berkshire Hathaway chairman Warren Buffett is a proponent of value investing.

P/E ratio is one of the most commonly used tools by value investors to help determine which stocks to buy. There is some subjectivity in this method. One trader might consider stocks with a P/E ratio of 10 to be a good value while another might only purchase investments with a 7 P/E ratio.

Low P/E ratios are not an indication of low risk. One caveat to this type of value investing is that a company might have a low P/E ratio because its earnings are in decline. In that situation, a low P/E number could be a sign that a company is in distress instead of just reflecting an undervalued investment opportunity. A good example is Ford. In April 2005 its P/E ratio peaked at about 32 with a share price of about 16. In September 2005 the stock price reached 29 and the P/E ratio was still near 30. But investors lost confidence and by the end of the year, the share price had fallen to 9 and the P/E ratio was at 8. But even at that low P/E ratio the stock price continued to fall. Today the stock is trading at about $3 a share and no P/E ratio is available because of a negative corporate earnings.

Conversely, high P/E ratios are not always negative. A company can have a high ratio because it has a favorable earnings outlook or because it is in a strong growth mode. On the other hand, a high P/E ratio can also indicate a speculative bubble. During the technology boom of the late 1990s many tech firms had extremely high P/E ratios (60 or more) because people believed the firms had unlimited growth potential. Some that survived have seen their P/E ratios decline to more typical levels. Others went under. And some still have ratios that are considered quite high.

Companies with no earnings usually have an undefined P/E ratio. This P/E ratio will usually appear as 0 or as N/A. Companies with losses (negative earnings) are also usually treated as having an undefined P/E ratio, even though it is possible to mathematically determine a negative P/E ratio.

As the current earnings season unfolds, it is important for investors to understand that corporations will always try to do whatever they can to present earnings numbers in the most favorable light. But positive earnings reports and solid P/E ratios are not always reliable indicators for determining whether a stock represents a good value.
F.S.