Using Relative Valuation To Compare Stocks | P/E Ratio

Key Points

• Relative value has proven to be an effective way to evaluate the cost of investing in a company. This is comparing the valuation of a business (typically by P/E ratio) to other companies in the same industry.
• The P/E ratio is a financial metric investors utilize to measure the common stock price in relation to what a company Earns Per Share(EPS). Price/EPS.
• Digging deeper there are many things you can compare to: the broader market (say the P/E of the index), the sector, the industry and even the closest competitors.
• You might even compare the current P/E ratio to the historical average for that same company. 
• This shouldn’t be the be all and end all of your investment decision as oftentimes companies with a higher multiple deserve it. However it is a key metric to help guide you. 

Apples to Apples(Stocks in The Same Industry)

Relative Valuation is a process by which investors compare a company’s value to those in their specific industry and represents the concept of an apples to apples comparison. 

For investors, there can be a Focus on Trying to Be in the Right Sector when it comes to their investment strategy. This might be due to a change in the outlook for a specific sector/industry and thus attract capital inflows because the market might be undervaluing companies in it. Regardless, investors are anticipating solid results over the long-term. 

Some investors may take a passive investment approach and invest in an ETF mirroring an index or basket of stocks representing a particular sector/industry. Others may attempt to take an active investment approach hoping to select a company that will outperform their competitors over the long-term. 

Comparing Stock Price to Past Earnings and Future Growth

Utilizing the Dividend Discount Model(DDM), Free Cash Flow(FCF) or other Discounted Cash Flow Models(DCF) can still be useful for investors when trying to determine the intrinsic value of a single company in a sector/industry. 

This is referred to as Absolute Valuation and differs from the concept of Relative Valuation but can be used in accordance when determining whether or not a company is worthy of investing. 

When it comes to using Relative Valuation, the emphasis is usually on two financial metrics referred to as the P/E Ratio and Forward P/E Ratio. These are also known as earning multiples and give investors an idea if a stock is trading at an expensive or inexpensive price in relation to their earnings. 

This is why relative valuation is important when comparing apples to apples. If companies are offering competing products or services, it can be useful to compare them on the basis of their earning multiples.

What is the P/E Ratio? What Does It Tell Investors?

The P/E ratio is a financial metric investors utilize to measure the common stock price in relation to what a company earns per share(EPS). To calculate this, divide the market value per share by the earnings per share(EPS). All of this information is public and is represented by the below formula.

P/E Ratio= Stock Price/ Earnings per Share

The P/E Ratio essentially tells an investor how much they would be willing to pay for the company’s earnings. Think about it through the quote of “XYZ company is trading at 20 times earnings”. Equity markets are by nature always forward looking so companies naturally will trade above their recorded earnings usually.

One of the positive aspects of evaluating a company through the P/E Ratio is the fact it is captured through past reported earnings. Earnings per share is expressed through the TTM(Trailing Twelve Months) and allows investors to analyze on a historic basis. 

This also presents a downside as past performance is not indicative of future performance always. The question an investor is asking themself is if the company can continue to grow earnings like it has in the past. 

The general rule of thumb is if two companies in the same industry are identical when comparing their businesses meaning one does not have much advantage over the other; the company with the lower P/E ratio is usually deemed the better investment since it would be trading at a discount. 

This is what value investors such as Warren Buffet will search for but sometimes there is more to it when a company is trading at a higher P/E ratio and should require a little bit further research for the active investor to find out why? 

Are there changes occurring at a company that might make their business model more attractive over the long-term in comparison to their competitors? It is always important to understand why the market might value one company more than their competitors. Simply put, why do investors like one company so much more than a competitor?  

What is the Forward P/E Ratio? How Do I Compare It Against the P/E Ratio?

The Forward P/E Ratio takes into account forecasted earnings in the P/E ratio as a financial metric. When using the Forward P/E Ratio, analysts are estimating what a company’s earnings per share will be for the price multiple as opposed to using verified past earnings per share. It can be calculated by using the below formula.

Forward P/E Ratio= Stock Price/ Estimated Earnings per Share

In some instances, investors might be deterred from a company trading at a high P/E Ratio but if their business outlook remains robust, it is possible the Forward P/E Ratio might be less than the P/E Ratio because analysts are expecting the company to continue to grow their earnings. 

This itself can give a different look as to whether or not a company’s stock is trading at an expensive price.  The downside with using the Forward P/E Ratio is that analysts might be wrong when it comes to calculating the expected earnings per share(EPS) and a company might report less due to unforeseen factors. 

When companies trade at a high earnings multiple, missed earnings can result in severe stock price declines because the company is priced for perfection. While the company might have impressive growth prospects, the herd might run the stock up making it entirely too expensive to make sense. Thus patience might be required at times and is a key characteristic to successful investing.

Use them Both When Analyzing Companies in the Same Industry

Using the P/E and Forward P/E Ratio is a popular means by which investors and analysts evaluate companies and in particular when it comes to using Relative Valuation. Both financial metrics are subject to fluctuation as the stock price moves up or down in value or as expected earnings changes due to business outlook. 

While the P/E Ratio is a useful metric to see where a company is trading at in relation to past earnings, the Forward P/E Ratio can give a slightly better idea of how expensive a company is trading at because of the estimated earnings per share. Both metrics can be very useful and used in conjunction with each other as expressed in the below example.

Nvidia(NVDA) vs. Intel(INTC) Example

Chips are a hot topic and a very common word buzzing around when it comes to business trends. This makes the semiconductor industry attractive in the eyes of investors but there are several reputable companies competing against each other. Intel has long been the industry leader and as of 10/29/2021 holds a P/E Ratio of 9.51.  

Intel is still a reputable company, but investors are not as optimistic about their earning prospects moving forward. This is also evident when analyzing their Forward P/E Ratio which tells investors the market actually thinks even at the current price, the stock still trades slightly higher than it should. 

A value investor might show interest and present a valid argument as to why it is worth investing if one has the patience to wait several years. On the contrary, another investor might argue Intel is a value trap and while they will not go bankrupt, their best days as a company might in fact be behind them.

Nvidia over the course of the past two years has gained strong attention from investors as they continue to grab market share and develop superior products according to industry experts. This is evident by the fact that as of 10/29/2021 Nvidia holds a P/E Ratio of 91.47 and a Forward P/E Ratio of 54.95. While still trading at a very expensive price, this shows investors how the market thinks Nvidia will continue to grow their earnings at a higher rate than most of their competitors and in this particular example Intel.

GenVest QuickTake

Markets are very efficient meaning investors are quick to allocate into the best companies which will drive the stock price up. Luckily, there will be market or even individual stock corrections bringing down the prices of many solid companies giving investors the chance to take a position when it is trading at a lower multiple. 

Volatility is normal in the equity markets but what long-term investors value the most is a strong business outlook and whether or not a company can grow their revenue/earnings and Free Cash Flow(FCF) for several years. 

This is why it is important to Be Bold When Others are Fearful and also why investors should consider Dollar Cost Averaging as a stock price is in the process of temporarily correcting itself. Essentially buy a little here and there periodically when the stock price is more attractive.