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P/E methods: Looking back versus looking ahead

Adam Zoll  |  21 Jan 2013Text size  Decrease  Increase  |  

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Adam Zoll is an assistant site editor with Morningstar US.


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 real estate investment trusts (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 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.

Each of the P/E methods used on has its pros and cons.