Arguments for P/E ratios:

• According to security analysts, earnings continue to be the primary driver of investment value.
• P/E is widely recognized and used by investors.
• Differences in price/earnings ratios may be related to differences in long-run average returns, according to empirical research.

Arguments against P/E ratios:

• P/E does not make economic sense with a negative EPS. As a result, only companies with positive earnings can be ranked according to their P/E ratios and a number of companies with negative earnings have to be excluded from this analysis.
• Volatile, transitory portion of earnings makes it difficult to calculate P/E, because only permanent or recurring income can be a determinant of the company's value. Splitting a company's earnings into recurring and period-specific elements is difficult.
• Management discretion in choice of accounting methods reduces comparability. For example, management may pursue income-smoothing policy which can significantly distort a company's net income and lead to inaccurate valuation of the company's stock if P/E is used.

In calculating a P/E ratio, the current price for publicly traded companies is generally easily obtained and unambiguous. Determining the earnings figure to be used in the denominator, however, is not as straightforward. Two issues are:

• The time horizon over which earnings are measured, which results in two chief alternative definitions of the price/earnings ratio; and
• Adjustments to accounting earnings that the analyst may make so that P/Es are comparable across companies.

Alternative Definitions of P/E

The two alternative definitions of P/E are trailing P/E and leading P/E.

• A trailing P/E (also current P/E) is a price multiple comparing the stock's current market price to the company's earnings during the last four fiscal quarters. The EPS in such calculations are sometimes referred to as trailing twelve months (TTM) EPS. Trailing P/E is the price/earnings ratio published in stock listings of financial newspapers.
• A leading P/E (also forward P/E or prospective P/E) is a price multiple comparing the stock's current market valuation with the company's forecasted earnings for the next full fiscal year or for the next four quarters.

Example

2009 earnings = $25 million
Forecasted EPS over the next 12 months = $0.60
50 million shares outstanding
Market price = $16.00
Calculate trailing and leading P/E ratios.

EPS₂₀₀₉ = $25,000,000 / 50,000,000 = $0.50.
Trailing P/E = $16 / $0.50 = 32.
Leading P/E = $16 / $0.60 = 26.7, which is significantly lower than the trailing multiple.

Trailing P/E

When calculating a P/E ratio using trailing earnings, care must be taken in determining the EPS number. The issues include:

• Transitory, nonrecurring components of earnings that are company-specific;
• Transitory components of earnings due to cyclicality (business or industry cyclicality);
• Differences in accounting methods; and
• Potential dilution of earnings per share.

Underlying earnings are earnings excluding nonrecurring components such as:

• Gains/losses on asset sales.
• Asset write-downs of impaired assets.
• Loss provisions, corporate restructurings, divestitures of business segments.
Extraordinary losses from repurchase of the company's debt prior to maturity.
• Changes in accounting estimates.

Example

2009 EPS = $8.00 Gain on asset sale = $1.40 Gain from change in accounting estimate = $0.75 Underlying earnings = $8.00 - $1.40 - $0.75 = $5.85.

Normalized EPS - Adjusting EPS to remove cyclical component of earnings

Earnings of many big companies such as those in automobile manufacturing, residential construction and air travel industries significantly depend on the aggregate demand in the economy, and earnings trends of them approximate the direction of general economic cycle. Because of cyclic effects, the most recent four quarters of earnings may not accurately reflect the average or long-term earnings power of the business.

Analysts address the problem of cyclicality by normalizing EPS - calculating the level of EPS that the business could achieve currently under mid-cyclical conditions (normal EPS).

Two normalization methods:

• The method of average return on equity:
  Normal EPS = Average Historical ROE x Current BV per share
  The averaging period for historical ROE calculation should encompass full previous economic cycle.

• The method of historical average EPS
  Mean EPS during the most recent cycle may be a good indicator of the normal level of earnings per share.

Example

Average return on equity method:
Average ROE = (0.15 + 0.15 + 0.21 + 0.16) / 4 = 0.1675.
Average ROE x BVPS2004 = 0.1675 x $28.00 = $4.69.

Historical average EPS method:
Average EPS = (4.00 + 3.80 + 5.25 + 4.5) / 4 = $4.39.

Earnings Yield

P/E multiple is meaningless if the earnings is negative. An analyst should use earnings yield (E/P: the reciprocal of the P/E multiple) for the ranking purposes.

It can be used to rank stocks from low E/P to high E/P:

• High E/P: under-priced.
• Low E/P: over-priced.