This is a guest post written by Dan Mac. Dan writes about investing in dividend growth stocks [1] at his site Dividend Growth Stock Investing. Dan recently released his Free Dividend Growth Investing Guide [2].
I often read investment articles discussing stocks of different companies worthy of investing in. Usually the author will give an opinion about the current valuation of the company. Is it over, under or fair valued? Many times these opinions will be given without a clear explanation of how this valuation was determined. While there are many factors that come into play when trying to get an idea of different companies’ valuation levels, the P/E ratio (price divided by earnings per share) is one of the easiest ways to get a quick idea of how the market is currently pricing a company.
What is the P/E Ratio?
The Price to Earnings Ratio is calculated by taking the most recent market price of a company and dividing it by the most recent annual EPS (earnings per share). Many investors will also look at the trailing twelve months P/E ratio (using last 4 quarters reported earnings) or the forward P/E ratio (using analyst estimates of next fiscal year earnings). Any of the ratios are fine to use although I would caution against using any overzealous analyst estimates that will skew your P/E ratio lower than it probably should be for valuation purposes.
Historically the average P/E ratio for the stock market has been right around 14. In bull markets, stocks will tend to trade at higher P/E ratios and in bear markets stocks will tend to trade lower. Sometimes, like during the dot.com bubble you will find companies trading at ridiculously high P/E ratios. It is best to be most cautious during these times and save up cash to invest at a later time when stocks will have inevitably fallen back to more reasonable levels. While you can use the historical market average to compare a stock’s current P/E level, there is a better way.
A Better Way to Use the P/E Ratio
Not all companies trade within the same range of P/E values. Different industries will tend to trade at higher or lower valuations compared to other industries. Companies with high growth rates of earnings will usually demand a higher P/E valuation compared to older more established blue chips with less growth. For this reason, the best way to use the current P/E ratio to get a beginning idea of current valuation is by comparing it to the particular company’s historical P/E average.
Let’s take a look at an example.
Coca-Cola (KO) is the world’s largest beverage company. They sell many brands around the globe including Coke, Sprite, Fanta and Powerade sports drink. The company has a long history of paying out annually increasing dividends. This streak continues on to 51 years as they just recently announced a dividend increase of 9.8%. The 10 year historical average P/E ratio for KO is 19.1. This shows that Coca-Cola usually trades above the total market historical average. If you were waiting for Coke to trade at a P/E below the historical market average of 14, you may be waiting a very long time.
Back in 2010, you would have had a once in a lifetime opportunity to purchase shares of Coca-Cola when it was trading at a P/E ratio of around 10 and a market price around $25 per share. Had you made this purchase, you would now own shares of KO worth right around $38 per share. This works out to a compounded average annual return of just under 15% for the 3 years you have held Coke stock. This worked out very well for the investor.
Back in 2008, you would have had an opportunity to purchase shares of Coca-Cola when it was trading at a P/E ratio of around 26. This is quite a bit higher than its past 10 year average P/E. The market price you would have paid would have been right around $32.75 per share. This would have worked out to a compounded average annual return of just over 3% for the 5 years you have owned the stock.
So which scenario works out better? Clearly the investor who bought at the much lower P/E of 10 fared way better than the investor who purchased at the P/E of 26.
Using the historical 10 year P/E average, we can form a reasonable guide that when trading at a P/E around 19, KO is trading at a fair valuation. When trading lower than 19, KO is undervalued and when trading higher than 19 Coca-Cola is overvalued. The farther away from the average, the more over or undervalued the stock is.
Currently, Coca-Cola is trading at a trailing twelve months P/E ratio around 19.3. This gives us an idea that Coca-Cola is currently trading right around its fair value. However, it is important to remember that P/E gives us just a quick picture of valuation and a full analysis of the company’s revenues, earnings, growth levels, debt levels and current news should be undertaken before making a final investing conclusion.
Conclusion
This scenario plays out again and again as you look over the numbers of different dividend growth companies [3]. Investors almost always fare better by buying shares of stock when they are trading at P/E ratios below their 10 year average compared to when they are trading at P/E ratios above their 10 year average.
However, keep in mind the risk that the future performance of any company is never guaranteed. This is why it is important to use the P/E compared to historical P/E ratio as an initial valuation guide but then be sure to dig deeper into the financials of any company before making any investing decisions.
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