PE

Matt just put out a post about metrics. The work on that led me to write this about the important PE ratio.

The price to earnings multiple tells us how much we would pay for each dollar of earnings. If all else is equal, the lower the multiple, the cheaper the stock. There are many versions of the PE, from the trailing twelve month (TTM) PE, to the forward earnings PE, to Shiller's cyclically adjusted price to earnings (CAPE) ratio. Here are instances when I find PE's especially useful (not an exhaustive list):

Example using PE

The TTM PE seems to be the most commonly used version, especially in summaries of stocks at financial websites. When I research individual stocks, I usually start at this screen, or one like it:

The PE's best use here is to reinforce the other important figures. The two most telling things on Microsoft's (MSFT) screen are the revenue and EBITDA (cash flow) figures. $85 and $27 billion reinforce the company's status as one of the most wildly profitable in history. The 2.55% dividend yield proves they send money to shareholders at a higher right than the average for S&P 500 companies.

Along with the $447 billion market cap (the total market value of the company), the 27 PE verifies that this company is no secret and that it will not be "easy" to make money owning it.

Continuing the query into MSFT will show how I use another version of the PE multiple. Knowing 27 slightly higher than the benchmark S&P 500 TTM PE of 25, I next wonder how it relates to its tech industry peers:

Google really is the best for directing me immediately toward the work of the best experts. Yardeni's packet of Forward P/Es is exactly what I want.

The exclusive use here of Forward P/Es (and not TTM) reminds me that after the very first search of a company, I usually never consider the TTM again. (Another useful version is Shiller's CAPE, but more on that later hopefully.) The Forward P/Es of course use estimates of future earnings, which because they are a form of future telling are inherently inaccurate, but they represent the best wisdom of the professionals who follow the companies and therefore are great for telling you exactly what you want to know: the optimism (or pessimism) of the market participants as reflected in the multiple.

So of course the TTM uses a more accurate picture of earnings because it uses what was earned in the past. But we aren't looking for an earnings number right now. We are asking how much the market likes the company, and therefore how expensive it is, versus its peers.

But first I have to calculate MSFT's Forward P/E:

56.57 (current quote) divided by 2.90 equals a Forward P/E for MSFT of 19.5, which you can see represents a premium versus the tech sector average:

As always the PE analysis I did here serves to help understand how investors value MSFT. The next steps in evaluating the investment opportunity have less to do with its PE, so I'll stop here for now.

Future post: CAPE