The price-to-earnings (P/E) ratio is undoubtedly the valuation measure most widely used by financial commentators and private investors. But there are P/E pitfalls that can lead you astray.
Smith & Nephew
Medical devices firm Smith & Nephew headlines its results with an adjusted earnings-per-share (EPS) number. This excludes exceptional or one-off items. Most companies do this (analyst forecasts are also made on the same basis), and its the adjusted EPS number that typically becomes the E in our P/E calculations.
Smith & Nephew reported adjusted EPS of 83.2 (about 53.7p) in its latest annual results, giving a P/E of 22 at a share price of 1,180p. However, if you look at those results, youll see that restructuring & rationalisation costs are one of the things the company excludes from its adjusted EPS. The trouble is that this exceptional item has appeared in Smith & Nephews results every year for the last 10 years bar one. Its not really a one-off is it?
The $46m (5.2 per share) of costs the company reported this year is about average. If we treat these costs simply as a normal feature of the business, Smith & Nephews already high P/E of 22 (compared with 16.7 for the FTSE 100 as a whole) goes up even higher to 23.5.
P/E pitfall: hidden recurring one-offs can lead your valuation astray.
If you look at BHP Billitons last annual results, youll find the company posted EPS of 252.7 (about 163p), giving a P/E of 9.8 at a share price of 1,600p. If you then go to the last annual results of Billitons big rival Rio Tinto, youll find Rio posted EPS of 503.4 (about 325p), giving a P/E of 9.7 at a share price of 3,150p.
Not much to choose between them, right? The trouble is Billiton has a 30 June financial year end, while Rio and all the other big Footsie miners have 31 December year ends. Rios P/E of 9.7 for the year ending 31 December 2014 is fine, but to compare Billiton on a meaningful basis, we need to take the latters EPS from the second half of its financial year ending 30 June 2014 and add it to the EPS for the first half of the year to 30 June 2015.
Doing the calculation produces EPS of 207.5 (about 134p), giving Billiton a P/E of 11.9. On a like-for-like basis, then, Billitons earnings rating is a good bit higher than Rios. You also need to go through a similar process of adjustment when calculating the two companies P/Es from analyst forecast earnings (although you may want to wait until the analysts have updated their forecasts after Billitons half-year results today.)
P/E pitfall: different company financial year ends can lead your comparative valuation astray.
Analyst earnings forecasts for the next two or three years are widely available on financial websites. Most of us look at forward P/Es probably more so than trailing P/Es.
One often-overlooked point when using forward P/Es is illustrated by AIM-listed Tungsten. This company, which is a leading global B2B e-invoicing network, whose customers include Tesco, GlaxoSmithKline and Unilever, isnt making a profit yet. However, the firm is forecast to deliver positive EPS in its financial year to 30 April 2017, giving a P/E of 12 at a share price of 170p.
But lets remind ourselves of exactly what a P/E is. The number represents how many years it would take for EPS to total the share price we paid (if EPS stayed the same).
In Tungstens case, we have a P/E of 12, but if we invest today, its not 12 years (to 2027) for EPS to equal our share price. The company, remember, is not yet profitable, so the clock doesnt start ticking until 2017. It would be 2029 for EPS to equal our share price 14 years, and thus effectively putting Tungsten on a P/E of 14.
P/E pitfall: you could be paying a higher valuation than you may think when using forward earnings.
Getting it right
There are plenty of pitfalls to guard against when it comes to investing, but avoiding the worst of them can produce fantastic long-term rewards.
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