PER As a Method of Determining a Company's Value
One of the most common methods in determining the intrinsic value of a company for your investment is calculating the Price-to-Earnings Ratio (PER). You can obtain the PER by dividing the market price by the earnings per share (EPS).
The PER is widely used to determine whether a stock is overvalued or undervalued. If a company's PER is higher than the overall market's or the industry's, it can be considered as expensive and vice versa.
Other than market or industry comparisons, a company's historical PER range can be used as a guide in determining the value of a stock. This method works well only when the company is in a steady state of growth with no earnings surprises in store.
The power of the PER range is in its capability in giving us a benchmark to decide whether a stock is expensive or cheap. Say, a company's average past five year PER range is 10 times to 20 times. If the company's current PER is lower than 15 times, then the company is considered cheap at the current price. Conversely, if it's higher than 15 times, it will be considered expensive.
Every company has its own historical PER range. Some companies are always selling at the higher end of their PER range due to their potential future earning power. In the meantime, certain stocks can be consistently trading at the lower end of their PER range for years, which may be attributed to high financial gearing or pending litigation. However, stocks with low PERs may be misinterpreted as being undervalued.
A company's PER range can be derived from an average of its past five year PER range. It's calculated by dividing the lowest and highest prices for every financial year with the audited earnings per share (EPS). After that, we find the average of the lowest and the highest PER for each year over a five year period.
The general historical PER range used is based on a past five year average. If a stock has been listed for less than five years, we can still use the historical PER range. However, it may be less convincing as compared with the complete five year average PER range. If the data available to us is more than five years, it's still preferable to use the most recent five year average range, as earlier PERs may not be relevant any more due to the changes in the company's fundamentals.
There are two types of PERs, known as trailing and leading. The main difference is the denominator used; with a trailing PER, the immediate past financial year (FY)'s EPS is used, while for a leading PER, the forecasted EPS over the next 12 months is used.
Most analysts use leading PER as it reflects the stock's current valuation. For instance, you intend to invest in Company M, which has a financial year-end of December 31st and its current stock price is $10. To determine the Company M's PER, we can use the FY2005 EPS rather than the FY2004 EPS, as we're currently in FY2005.
The PER range method is based on the assumption that each stock will always trade within its own historical PER range, which is simple and quite powerful. However, retailers may find it hard to apply, as the past five year average PER range is not simply available to the public.