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 consumer companies may often have higher P/E ratios compared to a company in a slow-growth industry with fewer prospects.
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.
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 Rs 100 per share with earnings per share of Rs 20 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.in 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.
Morningstar.in readers can find P/E data for a stock by visiting the stock's Quote page where the forward P/E is listed on top while trailing P/E is given in the Key Stats section below. Each of the P/E methods used on Morningstar.in has its pros and cons.
Backward-Looking P/E
Pro: Uses actual earnings data from the trailing 12-month period as opposed to potentially unreliable analyst projections.
Con: Does not anticipate factors that could affect future earnings, such as a new product launch or industry changes.
Forward-Looking P/E
Pro: May provide a more useful picture of future earnings performance that is of greater relevance to investors considering buying, selling, or holding a stock.
Con: Forecast may be inaccurate because of unforeseeable events or human error.
P/E and equity Funds
For equity and allocation funds, Morningstar provides a weighted average P/E based on stocks in a fund's portfolio and uses a proprietary version of the metric called the equity style box factor P/E.
Once an equity style box factor P/E is calculated for each stock in the fund's portfolio, it is then used, along with nine other style factors, to help determine where the fund fits within the Morningstar Style Box. (For more on the Morningstar Style Box Methodology, click here.)
For example, a fund's high P/E might suggest a growth strategy, whereas a lower P/E may indicate the fund takes a value-oriented approach.
The fact that the statistic is weighted means the P/Es of the fund's top holdings are going to be counted more heavily than the P/Es of smaller holdings.
Fund-level P/E information may be found under the fund page's Portfolio tab, in the Style Details section. There you will also find P/E data for the fund's benchmark and category average for comparison.
Key Tool for Value Strategy
P/E is often used by value investors to identify stocks that might be selling for less than they are worth. By screening on P/E ratio and other valuation metrics, value investors--and value fund managers--can come up with a list of companies that align with their strategy: buying undervalued stocks and holding them until their prices rise.
Although P/E can be a useful tool in evaluating the prices of stocks, funds, and the market in general, the metric doesn't tell the whole story. Other factors beyond P/E also need to be considered.
For example, when assessing a stock, you should look at company management and the outlook for the company, its industry, and the economy.
Likewise, a fund manager's process, experience, and track record are important to think about when evaluating funds. What P/E does provide is an indication of what could happen to the price of an individual stock, stocks held by a fund, or the overall market based on a set of assumptions. That can be helpful, but it's far from a guarantee.