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SECTION 3 OF THE SSG: PRICE-EARNINGS HISTORY

3 PRICE-EARNINGS HISTORY as an indicator of the future
This shows how stock prices have fluctuated with earnings and dividends. It is a building block for
translating earnings into future stock prices.

Stryker Corporation

PRESENT PRICE: 60.780

HIGH THIS YEAR: 76.890

LOW THIS YEAR: 54.900

 

GENERAL INFORMATION

This section examines the relationship between the company's earnings and the stock's price, in other words, its Price-Earnings history. It also addresses dividends and payout.

  • P/E stands for "Price-Earnings Ratio." P/E is the price you are willing to pay for each dollar of earnings. A P/E of 15 means people are willing to pay $15 for each dollar of earnings.
  • The standard calculation that BetterInvesting uses for P/E is current price divided by trailing four quarters of earnings per share (EPS). Trailing four quarters means the last four consecutive quarters of reported earnings.  There are other variations to calculating P/E; these will be discussed in the Advanced Section of this document.
  • P/E is also referred to as a "multiple."  A P/E tells how many times over shareholders will pay for each dollar of a company's earnings.  A company with a current stock price of $20 and an EPS of $2 has a P/E of 10 ($20 divided by $2).

Following are the common uses of P/E:

 

  • to determine historical average P/Es and compare them to a current P/E to determine over- and undervalued stocks (SSG Section 3-lines 8 and 9)

 

  • to use historical average P/Es, adjusted with judgment, to multiply future anticipated EPS to determine a range of fair prices in the future (SSG Sections 4-A and B), and

 

  • to project a future P/E based on next four quarters of EPS (directly under the chart in Section 3).

 

PRESENT PRICE, HIGH THIS YEAR, LOW THIS YEAR

 

The present price and 52-week high and low prices used on the SSG should be taken from an on-line source, such as www.finance.yahoo.com. Do NOT use Value Line figures-- they will not be the most current figures.

 

  • If the present price is near the 52-week high, the stock may not be a good value.
  • If the present price is near the 52-week low, look for reasons why. There may be a red flag.

 

Columns A and B: PRICE


Columns A and B show the high and low prices for the past five years.

 

  • Prices should be increasing over time. If not, this may be a red flag. Investigate.

 

Column C: Earnings per Share


Column C is the earnings per share (EPS) for the past five years.

 

  • Earnings, also known as net income or profits, should be increasing. If not, find out why not.

 

Columns D and E: Price Earnings (P/E) Ratio 

 

The P/E ratio is calculated by dividing the stock price by the company’s earnings.  Columns D and E are the most critical columns in section 3. These two columns show the high price divided by the EPS and the low price divided by the EPS for the past five years. Examine the high and the low P/Es.  What is the trend?  Are the P/Es increasing, decreasing, or remaining about the same? They should be increasing.

 

  • It is difficult to decide which P/Es are outliers.  Some individuals look at the company’s 10-K report to find out what happened to create the anomalies.  It could be an earnings problem, a temporary problem, or market euphoria.

 

  • Look carefully for any anomalies or "outliers" for the past five years in columns D and E. There may be a very high or low P/E for one or more years. These inflated or deflated figures can skew the average high P/E or low P/E so that it makes your future high and low prices (in sections 4-A and 4-B) too high. If you are using a software program, eliminate "outliers" by clicking on the specific figure you want to eliminate. A red line will cross through the figure, indicating it has been eliminated.

 

  • A rule of thumb is to eliminate any figures which differ 30% or more from the "norm" value or "base" value. You can determine a base figure by looking at the past five years of high P/Es and selecting one year which represents the norm. For example, of the following high P/Es: 27, 30, 32, 58, and 55 you might choose 30 as the norm. Thirty percent of 30 is 9; thus the high P/Es of 58 and 55 would be eliminated because they differ more than 30% or differ more than 9 points from the high P/E of 30. You also can do this for the low P/Es in column E. You do not have to eliminate high and low figures in the same year. On average, don't drop more than two figures from each column.

 

  • For most companies, the five-year period of Price Earnings Ratios in Section 3 is sufficient to get a feel for the top and bottom of a normal business cycle. However, for companies such as "tech" stocks that surged during the latter half of the 1990's, it is better to look 10 years into the past and not just 5 years in order to obtain a more reasonable average.  The Toolkit software allows you to look at each of the high and low P/Es for a company over its most recent 10-year history.  To view this, go to Section 4 of the SSG.  Left click in the green box in Section 4A or Section 4B to bring up a box entitled “Judgment – Average High/Low P/E.”  On this screen you will see the 10-year history plus the Average High P/E and the Average Low P/E for those 10 years.  The average is recorded underneath the last reported fiscal year figures.  These figures will be referred to in Sections 4A and 4B.

 

  • For an advanced method of weighting the P/Es to get a truer picture of what is likely to happen in the future of the company, see the advanced tips section.

Line 8 in Section 3 is the average historical P/E for the past five years. This number is determined by averaging the numbers in line 7 of columns D and E. If no numbers or outliers have been eliminated in columns D and E, the average price earnings ratio is referred to as the historical P/E. However, if you have eliminated some numbers in the columns D and/or E, then line 8 is called the "signature" P/E. The signature P/E may be a more reasonable indicator of the price earnings history because it has eliminated some of the anomalies.

Line 9 is the current P/E based on the last four quarters. Compare the current P/E in line 9 to the average historical P/E or signature P/E on line 8.

 

  • The closer the current P/E is to the historical or signature P/E, the better value the stock. The further apart the numbers, the more under or over valued the stock.

 

Compare the current P/E to the industry average annual P/E (on Value Line industry sheet). The SSG also prints the Projected P/E based on the next 4 quarters. This projected P/E is based on the estimated earnings per share growth you entered at the bottom of page 1 of the SSG. If the projected P/E is higher, that is favorable. If it is lower than the current P/E, that may be signaling a slow down in growth and a slow down in price appreciation.

 

Column F: Dividends Per Share


Most high growth companies do not pay dividends because they prefer to use the money to grow and expand. Other companies may pay very good dividends. Depending on the philosophy of the company, dividends may vary or may remain the same year in and year out. For example, a company may make a conscious decision to always pay a constant dividend, knowing that there are investors (e.g., widows and orphans) who want the stability of knowing they will get a constant dividend check to help pay for household expenses.

 

Column G: Percent Payout of Earnings as Dividends

 

This column indicates what percent of earnings are paid out to shareholders as dividends.

 

  • Generally the pay out rate should be no more than 50%.

 

  • If the percent payout remains relatively constant, the company probably has a dividend policy that is consistent over time.

 

  • If the percent pay out increases over time, this might be reason for concern because it may mean management's expectations for investment opportunities are diminishing. The company may be retaining less money to use for growth and new investment opportunities. They think the shareholders can make more interest on the money than the company can by reinvesting it back into the company.

 

  • If the percent payout decreases over time, it may mean the company found internal opportunities to reinvest the dividends to help the company grow.

 

  • See Section 5 of the SSG (5-Year Potential Percent Payout) for information on using judgment/outliers for column G.

 

Column H: Dividend Yield

 

Dividend yield indicates the effective yield that the stock’s dividend produces.  The yield is a financial ratio and is a way of looking at what percent the dividend pays in relation to the stock’s current trading price.

 

Formula to calculate the dividend yield is:

  Step 1:  Divide the dividend by the current price of the stock.

  Step 2:  Multiply the result by 100 to convert the number to a percent.

 

   Example:  (Annual dividend per share ÷ current price per share) x 100

                    Stryker’s annual dividend per share is $.22 per share.

                    Stryker’s current stock price per share is $60.78.

                    The math:

                         Step 1: .22 ÷ 60.78 = .0036

                         Step 2: .0036 x 100 = .36 or .4% is the current dividend yield for Stryker (SYK)

Another way of stating this is that for every dollar a shareholder invested to purchase a share of stock at the current stock price, the investor is receiving $.004 per share from the dividend.

 

ADVANCED TIPS OR SUGGESTIONS:

 

Weighting the P/Es in Section 3 to Determine Future Stock Price

 

If the P/Es have been trending up or down in one direction, you might not get an accurate picture for evaluating future risk and reward over the next 5 years if you just use the average of the five years, as provided in section 3, line 8. A more advanced method is to weight the high P/E and the low P/E for the past five years.

 

  • In the following example, multiply each P/E by 5,4,3,2,1 from the most recent year to the past five years. This puts the emphasis on the most recent P/E to get a better indicator of future P/E. For example, assume that the P/Es in Section 3 were as follows:

 

Unweighted P/Es

year

High P/E

Low P/E

1997

51.1

16.8

1998

37.8

16.4

1999

33.8

14.3

2000

28.1

14.6

2001

21.6

12.4

Total

172.4

74.5

Average

172.4/5=34.48

74.5/5=14.9


Source: "Advanced SSG Topics," Bob Adams, NAIC Congress, Philadelphia, August 2000

Multiply each year by 5,4,3,2, and 1 from the most recent year to the past five years. Then divide the total by 15 not 5 (because the 5,4,3,2,1 adds up to 15).

 

Weighted P/Es

year

high P/E

low P/E

1997

51.1 x 1 = 51.1

16.8x 1 = 16.8

1998

37.8x 2 = 75.6

16.4x 2 = 32.8

1999

33.8x 3 = 101.4

14.3x 3 = 42.9

2000

28.1x 4 =112.4

14.6x 4 = 58.4

2001

21.6x 5 =108.0

12.4x 5 = 62.0

Total

448.5

212.9

Average

448.5/15=29.9

212.9/15=14.2

 

Source: "Advanced SSG Topics," Bob Adams, NAIC Congress, Philadelphia, August 2000

Before weighting, the average high P/E was 34.48. After weighting it is 29.9. This high P/E is used to determine the high price in Section 4, line 1. Thus, the weighting process may provide a more reasonable high P/E figure that is more indicative of the future trend of the P/E for this company. The same goes for the Low P/E. Before weighting, the Low P/E was 14.9. After weighting it is 14.2. This number will be used to determine the low price five years out (Section 4-B). If the values are too high, for both the high and low P/Es, then values in Section 4 will be affected adversely. Bob Adams, a BetterInvesting presenter, likes to weight the P/Es because he thinks you get a truer picture of what is likely to happen in the future of the company. However, not all individuals believe in weighting the P/Es.

Other Variations to Calculating P/E


As mentioned in the General Information Section of this section of the SSG, there are numerous ways to calculate P/E:

 

  • Price divided by trailing four quarters of earnings per share (EPS). Trailing four quarters means the last four consecutive quarters of reported earnings (the standard calculation that BetterInvesting uses in Toolkit SSG).

 

  • Price divided by the company's last complete full calendar or fiscal year four quarters of EPS.

 

  • Price using two trailing quarters and two forward quarters of EPS (as stated on Value Line)

.

  • Price divided by future four quarters of EPS.

 

  • Price using future estimated EPS for two or more years into the future.

 

BetterInvesting, Value Line, and analysts may use different prices to determine the P/E.  The PRICE part of the equation in the P/E can be:

 

  • Current price (today's price)

 

  • Average price over several years

 

  • Most recent end-of-quarter price

 

  • Recent fiscal year price

 

  • Recent calendar year price

 

  • Calendar year price used for a company on a different fiscal year

 

  • Estimated future price

 

BetterInvesting, Value Line, and analysts may use different EPS values to determine the P/E.  The EPS variable in the equation can be:

 

  • Current earnings (most recent trailing four consecutive quarters)

 

  • Average earnings over several years · recently reported quarterly earnings plus an estimate for the current quarter

 

  • Most recent calendar or fiscal year earnings

 

  • All estimated future earnings

 

Keep in mind:

 

  • The SSG uses some, not all, of these variables.

 

  • The SSG may conflict with P/E ratios on analyst and other data sites because they use different prices and earnings to determine P/E.

 

  • Some sources use data "as reported" and some, like Value Line, "normalize" the data. This will affect the final EPS number in the P/E calculation.

 

  • Stick with one data source for your SSG data. Don't pull from a variety of sources. This is because different sources will use different prices (current price vs. end of quarter price to calculate P/E), different earnings (trailing four quarters vs. reported quarterly earnings plus future estimated earnings), and some sources will use normalized data (Value Line) while others will use actual data (Standard and Poors)).

 

Sources:

 

"What's a P/E, and What's it to Me?," Ellis Traub, Better Investing, March 2001, pp. 16-18.

"Interpretation of the Stock Selection Guide," Julie M. Werner, NAIC Congress, Philadelphia, August 2000.

"Basics-Get Your P/Es in Gear," Laura Berkowitz, NAIC Investor's School Transcript, June 25, 2001. www.better-investing.org/chats/transcriptlist.html. Scroll down the page and click on the title "Basics-Get Your P/Es in Gear"

"Basics-PE Judgment," Cy Lynch, NAIC Yahoo Chat, Nov. 15, 1999. www.better-investing.org/chats/transcriptlist.html. Scroll down the page and click on the title "Basics-PE Judgment."

"Advanced SSG Topics," Bob Adams, NAIC Congress, Philadelphia, August 2000. The charts used to describe weighted and unweighted P/E's came from Bob Adams' handouts and presentation at the NAIC Congress. .