Contents of this article
What is the P/E ratio?
The P/E ratio is the ratio of the share price to EPS (the price-to-earnings ratio).
EPS is earnings per share, calculated as profit after tax divided by the number of shares outstanding.
From the formula above, we can also rearrange it as:
It tells you how many times EPS the share price is, or how many times its profit after tax the company’s current market value is.
You can easily calculate P/E from readily available market data, or look it up from stock data providers.
What the P/E ratio tells you
The P/E ratio tells you how much you have to pay to receive 1 dong of the company’s earnings. For example, if a stock has a P/E of 8, buying it means you accept paying 8 dong of capital for every 1 dong of the company’s earnings. It also means it would take you 8 years to recoup your initial investment in the company.
The inverse of P/E is E/P, the earnings yield, which tells you the return relative to the share price. For the stock above, the earnings yield is 1/8 = 12.5%, meaning the stock could give you a 12.5% return if bought at the current price. You can compare this with a risk-free rate, such as the 12-month savings deposit rate.
Trailing P/E
Trailing P/E is calculated as the current share price divided by the EPS (price-to-earnings ratio) of the reporting periods over the most recent year (4 quarters). The P/E you find in market data is the trailing P/E, because it uses the most up-to-date data. Trailing P/E changes constantly because the share price changes constantly.
Investing in stocks is about future value, yet trailing P/E only reflects past earnings. In the example above, if you buy a stock with a trailing P/E of 8, you have paid 8 dong for 1 dong of the company’s earnings. However, this only holds if the company’s earnings next year are similar to last year’s.
Forward P/E
Forward P/E is calculated as the current share price divided by the company’s projected future EPS. Forward P/E reflects future value and the real yield the stock offers you more accurately. If a company has a forward P/E of 7, investors are willing to pay 7 dong for 1 dong of the company’s future earnings, equivalent to an earnings yield of 14.28%.
Unlike trailing P/E, forward P/E uses projected EPS. This figure is not readily available; you have to analyse the business and forecast its future earnings. Research reports from brokerage firms also give projected EPS and forward P/E figures based on their own views. These numbers can differ, and you can use any that look reasonable as a reference.
Whereas trailing P/E is merely a market statistic, forward P/E is precisely the number investors should weigh when deciding whether to invest in a stock, and it is also the number used to value it.
Using P/E to value stocks
One of the biggest uses of the P/E ratio is stock valuation. P/E valuation is the most widely used valuation method among investors and analysts today.
To find a stock’s fair value, you need to determine 2 things: projected EPS and a reasonable P/E. All that is left is to multiply the two.
*A projection is a forecast of next year’s revenue based on the company’s growth rate in previous years.
Projecting EPS
To project a company’s earnings, you need to break down its business segments and determine each segment’s share of profit. Then project the growth rate of each segment to arrive at projected earnings. If the business environment is unchanged, you can assume EPS will keep growing at its rate over the past 3–5 years. If the company has new expansion projects, you need a well-reasoned estimate of the revenue and profit those projects will bring, then combine everything to calculate projected EPS.
Projecting the P/E multiple
Usually, you can take a stock’s fair P/E to be the company’s own historical average P/E, provided it has maintained its market share and competitive advantage. Alternatively, you can use the industry average P/E to value the stock, though it should be adjusted for the company’s risk. Industry average P/E is easy to look up here.
An important point when using the industry average P/E: take it from a group of companies with similar business activities and size, rather than picking a generic P/E. For example, within the power sector, hydropower companies tend to trade at higher P/E ratios than thermal power companies.
A company’s P/E also depends on how risky the business is. For large-cap companies that lead their industry in market share and have strong finances, risk is relatively low and investors are willing to pay a higher P/E for these stocks. Conversely, small-cap companies without a strong industry position will only command a low P/E.
If you have no experience valuing stocks yet, the simplest way to learn is to study research reports from brokerage firms.
A real-world example of P/E valuation
Here is the simplest possible example of using the P/E method to quickly value VNM stock in 2022.
Vinamilk is the leader of the dairy industry, which is in a mature, saturated stage. In addition, the consumer staples sector was barely affected by COVID-19, so the company should sustain revenue growth of 5–7%, as it has for many years. According to management, input material prices will ease in 2022, helping the company improve its profit margins, which had been squeezed in 2020 and 2021.
I therefore forecast VNM’s 2022 profit after tax at VND 11,950 billion, up 9% from 2021, equivalent to EPS of VND 5,720 per share. To project P/E, I used Fialda’s historical data and found that the stock has traded at an average 5-year P/E of about 21.
We can therefore estimate VNM’s fair value in 2022 = 5,720 x 21 = VND 120,100.
Happy trading!
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