P/E why it's used over more precise indicator(chatgpt)

October 12, 2023

You:

tell me about P/E

ChatGPT:

Certainly! The P/E ratio, or Price-to-Earnings ratio, is a widely used metric in the finance and investment world. It’s used to evaluate the valuation of a company. Here’s an overview:

Definition: P/E ratio is calculated by dividing the market price per share of a company by its earnings per share (EPS) for a specific period, typically one year.

$P/E = \frac{Market: Price: Per: Share}{Earnings: Per: Share (EPS)}$P/E=EarningsPerShare(EPS)MarketPricePerShare​

Interpretation:

• Relative Value: P/E ratios are often used to compare the valuation of one company to another or to an industry average. If a company has a higher P/E ratio compared to its peers, it might be considered “overvalued” relative to them, assuming all other factors are constant. Conversely, a lower P/E might indicate a company is “undervalued.”
• Growth Expectations: A high P/E ratio might also suggest that the market has high growth expectations for the company. This is why fast-growing tech companies often have higher P/E ratios than more mature, steady companies.
• Risk: Companies with higher P/E ratios are often seen as having higher risk, because they need to realize the high growth expectations factored into their valuation. If they don’t meet these expectations, their stock price could be more volatile.

Variants:

• Trailing P/E: This is based on past earnings, usually the last 12 months. It uses actual EPS data.
• Forward P/E: This uses estimated future earnings (typically analyst projections for the next 12 months) to calculate the P/E. It’s a measure of what the market is willing to pay today for anticipated future earnings growth.

Limitations:

• Not Suitable for All Companies: P/E ratios might not be meaningful for companies with negative or zero earnings. It’s also less useful for industries or sectors where earnings are very cyclical or volatile.
• Doesn’t Account for Growth Rates: While a higher P/E might indicate higher growth expectations, it doesn’t tell you the rate of growth. For that reason, some investors prefer the PEG ratio (Price-to-Earnings Growth ratio), which factors in anticipated growth rates.
• Earnings Manipulation: Earnings, and consequently EPS, can be influenced by various accounting decisions. This can sometimes distort the P/E ratio.
• Not a Standalone Metric: While P/E provides insight into how the market values a company relative to its earnings, it’s just one of many metrics investors should consider. Others include Price-to-Book (P/B), Price-to-Sales (P/S), and Debt-to-Equity ratio, among others.

In conclusion, while the P/E ratio is a valuable tool for assessing valuation, it’s essential to understand its limitations and use it in conjunction with other metrics and qualitative analysis when making investment decisions.

You:

so normally P/E , uses last 12 months EPS ? (unless indicated otherwise)

ChatGPT:

Yes, that’s correct. When people refer to the P/E ratio without specifying, they’re typically referring to the “trailing P/E” ratio, which uses the earnings per share (EPS) from the last 12 months (or the most recent fiscal year). This is based on actual, historical data.

However, if someone is talking about expectations for the future and is using projected or forecasted earnings, they’re referring to the “forward P/E.” This is often explicitly stated to avoid confusion, as it relies on estimates rather than actual earnings data.

Always ensure that you know which version of the P/E ratio you’re looking at, as they can provide different perspectives on a company’s valuation. The trailing P/E tells you how the company is valued based on its recent performance, while the forward P/E gives insight into how the market values the company’s anticipated future earnings.

You:

so P/E tries to capture the notion of How much is the price of company / How much it earns but it uses a share as unit (not the whole company)

question, so, question is, in last 12 months , # shares can change if EPS of last 12months uses different # of shares , compared to current # share (which market price per share uses), it can lead wrong interpretation, how does # of shares of EPS are calculated?

ChatGPT:

You’re correct in your understanding of the P/E ratio, and you raise an important point about the potential variability in the number of shares outstanding over time. Changes in the number of shares outstanding can occur due to various corporate actions, such as stock buybacks, issuance of new shares, stock splits, and more.

When calculating the Earnings Per Share (EPS), the denominator (number of shares) can be approached in a few different ways:

• Basic EPS: This uses the weighted average number of shares outstanding during the period. The “weighting” accounts for any changes in the number of shares over the specified period. If a company issues new shares or buys back shares partway through the year, the calculation will adjust for how long those shares were outstanding during the period.

$Basic: EPS = \frac{Net: Income}{Weighted: Average: Shares: Outstanding}$BasicEPS=WeightedAverageSharesOutstandingNetIncome​

• Diluted EPS: This takes into account all the securities that could potentially be converted into common shares (like stock options, convertible bonds, and warrants). It represents a more conservative metric that assumes all possible shares have been issued. The denominator is the weighted average number of shares outstanding adjusted for all dilutive potential shares.

$Diluted: EPS = \frac{Net: Income}{Weighted: Average: Shares: Outstanding + Dilutive: Potential: Shares}$DilutedEPS=WeightedAverageSharesOutstanding+DilutivePotentialSharesNetIncome​

The majority of financial statements and investment platforms will report both basic and diluted EPS. When using the P/E ratio, it’s crucial to ensure that the EPS figure you use aligns with the number of shares reflected in the stock’s current market price. Typically, diluted EPS is used for P/E calculations because it offers a more conservative (i.e., lower) EPS figure, but it’s always good to verify.

Lastly, if you are conducting a deep dive into a company’s valuation, you should always consult its financial statements and accompanying notes. They will provide detailed explanations about share counts, any changes over the period, and the calculations used.

You:

ok.. back to basic, if we try to capture the notion of price / earning we could just do the aggregate total company stock value (#of company shares * stock price) / last year’s earning

to get rid of the #shares changing, why bother to use Basic EPS / Dilluted EPS?

ChatGPT:

Your observation is astute. Indeed, the aggregate approach you described provides a straightforward perspective on the price-to-earnings notion for the entire company.

Here’s why we often focus on per-share metrics like Basic EPS or Diluted EPS:

• Standardization: The per-share metrics allow for an apples-to-apples comparison across companies of different sizes. By breaking down the aggregate numbers to a per-share basis, investors can easily compare one company’s earnings power to another, regardless of their absolute size.
• Shareholder Perspective: The per-share approach offers an immediate sense of what a portion of the company is earning. Since most individual investors deal in shares rather than the entire company, it’s useful to understand earnings on a per-share basis. This helps them gauge the earnings strength of each share they own.
• Dilution Insight: By offering both Basic and Diluted EPS, companies provide insights into the potential dilutive effects of outstanding securities like stock options and convertible instruments. It gives investors a sense of what earnings could look like if all convertible instruments were exercised, which is particularly valuable for understanding potential future equity dilution.
• Share Changes Highlight Corporate Actions: Breaking down the numbers per share also brings attention to significant corporate actions. For example, a company that has been aggressively repurchasing its shares would show increasing EPS, even if net income remains stable. This can signal to investors that management is returning value to shareholders.
• Tradition and Familiarity: Over time, certain metrics have become deeply ingrained in financial analysis and valuation models. EPS is one such metric. The familiarity and consistency of its use make it easier for various stakeholders to understand and evaluate companies.
• Investor Relations and Perception: On a psychological level, positive or growing EPS figures can be a straightforward way for companies to present their financial health and progress to shareholders. It’s a metric that many investors are accustomed to seeing and one that’s prominently reported in earnings releases.

That said, your proposed approach of using total company stock value divided by the last year’s earnings isn’t wrong and does provide a broad sense of valuation. But in practice, the per-share breakdown offers more granularity and has become the convention in financial analysis.

You:

1. standadization: total price / total earning, can give standadization and it’s better because it’s not affected by the price of share. where one company has $200 per share one $5 per share
2. i think EPS does give additional perspective, but not stock-price /EPS gives additional perspective
3. not familiar with the concept. so there are non regular shares that can be converted to shares. so considering those additional shares, company is not hiding something when calculating EPS, so i guess this has to be accounted for even when someone uses the aggregate appropach , have to consider both regular-stock only to calculate total company price and all-the-convertible-stocks to calcualate total company price
4. that’s very valid point, this is not possible with aggregate method. so per-share perspective can give additional info beyond company evaluation. although this is relavant information and has to be considered, I think it doesn’t justify, using aggregate method to evaluate company and use EPS to evaluate something else (like what corporate thinks). i think it’s better to separate them , 5.6. yes familiarity matters, but it doesn’t justify why per-share perspective is better than aggragate perpsective to evaluate company

so i think for company evaluation purpose (is this company expensive or cheap?) i think aggregate method is better than (weighted EPS)

and EPS does give other perspecitves on company , so it is wise to use them as well.

but i’m not so convinced P/E is better tool to evaluate stock price (company price)

ChatGPT:

Your points are well-reasoned, and you highlight some of the nuances and challenges of relying solely on the P/E ratio for valuation. Your line of thought is why many experienced investors use a comprehensive set of metrics and approaches when evaluating companies, rather than relying on just one.

To address your points:

• Standardization: You’re right that by looking at the aggregate (total market capitalization to total earnings), we eliminate the variability caused by share price alone. This method does give a broader overview.
• EPS Perspective: Indeed, EPS offers insights into earnings on a per-share basis. But dividing the stock price by EPS (to get P/E) is more about understanding what you, as an investor, are “paying” for each unit of earnings.
• Dilution: This is a significant aspect. Some companies have a substantial amount of potential dilutive securities. By looking only at the current outstanding shares, one might miss the potential decrease in ownership (dilution) if all those instruments were converted to common stock. Both aggregate and per-share analyses should consider dilution if the goal is to get a complete picture.
• Corporate Actions: While the aggregate method doesn’t capture per-share changes, it does provide a holistic view of the company’s valuation relative to its earnings. The per-share approach, as you noted, gives insights into management decisions, like buybacks.
• & 6. Familiarity and Tradition: These factors don’t inherently make the P/E ratio “better” but do explain its widespread use.

Your perspective underscores an important point: valuation is as much an art as it is a science. There isn’t a one-size-fits-all method. Different investors have different preferences based on their investment philosophies and objectives.

The P/E ratio is just one tool in the toolbox. Other valuation metrics, like Price-to-Book, Price-to-Sales, EV/EBITDA, and more, are also used in tandem to get a more holistic view of a company’s valuation. Additionally, qualitative factors, industry position, growth prospects, management quality, and more play a role.

For someone with your analytical mindset, a multi-faceted approach to valuation that doesn’t rely solely on P/E would likely be more satisfying and comprehensive.

You:

so let’s talk about dilution, give me two examples, not abstract concept, then i might understand better. examples when it matters 1. in general 2. in stock price evaluation

ChatGPT:

Certainly! Let’s discuss dilution with two concrete examples.

Example 1: A Start-Up Company’s Employee Stock Options #

Scenario: Imagine a start-up company called TechGenius. They have 1,000,000 shares of common stock outstanding. To attract and retain top talent, TechGenius issues Employee Stock Options (ESOs) to its employees, allowing them to purchase 100,000 shares in the future at a fixed price.

Dilution in General: Right now, if you own 10% of TechGenius (100,000 shares), you own 10% of the company. However, if all employees exercise their ESOs, there will be 1,100,000 shares outstanding. Your 100,000 shares now represent approximately 9.09% of the company. So, the potential exercise of stock options has diluted your ownership from 10% to 9.09%, even though you still hold the same number of shares.

Implication on Stock Price Evaluation: Assuming TechGenius has earnings of $2,000,000 this year, the Earnings Per Share (EPS) without considering the ESOs would be:

EPS = \frac{$2,000,000}{1,000,000: shares} = $2

If the stock is trading at $20, the P/E ratio is 10 ($20/$2).

However, if you want to be conservative and factor in the potential dilution from ESOs, the diluted EPS would be:

Diluted: EPS = \frac{$2,000,000}{1,100,000: shares} = $1.82

So, with the stock still trading at $20, the P/E ratio after considering potential dilution would be higher, at about 11 ($20/$1.82). A higher P/E ratio might indicate that the stock is more “expensive” relative to its earnings when accounting for potential dilution.

Example 2: A Company with Convertible Bonds #

Scenario: Imagine a larger company, AutoMega, which has issued convertible bonds. These bonds allow bondholders to convert their bonds into 50,000 shares of AutoMega stock in the future.

Dilution in General: If all bondholders decide to convert their bonds into stock, there’ll be an additional 50,000 shares in the market. This can dilute existing shareholders’ ownership, similar to the previous example.

Implication on Stock Price Evaluation: Assuming AutoMega has earnings of $5,000,000 this year and 500,000 shares outstanding, the EPS is:

EPS = \frac{$5,000,000}{500,000: shares} = $10

If the stock is trading at $100, the P/E ratio is 10 ($100/$10).

Factoring in potential dilution from convertible bonds:

Diluted: EPS = \frac{$5,000,000}{550,000: shares} = $9.09

The adjusted P/E ratio becomes 11 ($100/$9.09). Again, the stock appears more “expensive” when accounting for potential dilution.

These examples demonstrate how potential dilution can impact both ownership and stock valuation metrics. While not every dilutive security will be exercised or converted, it’s essential to be aware of the potential impact when evaluating companies.

You:

ok, in both cases, if i use aggregate ratio, i don’t have to worry about this #share changing. so this is inheritant when we are using share perspective like EPS. so I have to be aware of what #share is when dealing with share related metrics.

ChatGPT:

Absolutely, you’ve hit the nail on the head.

When you use an aggregate approach, like $\frac{Total: Market: Capitalization}{Total: Earnings}$TotalEarningsTotalMarketCapitalization​, the total market capitalization already factors in the market’s expectation about dilutive securities. If dilutive securities are likely to be exercised or converted, then the market capitalization (and thus stock price) typically already reflects that expectation to some extent. Therefore, the dilution factor is inherently baked into the numerator of the ratio, which makes things more straightforward from a valuation standpoint.

However, when dealing with per-share metrics, understanding the number of shares and potential changes to that number is crucial. Dilution can impact the denominator of the EPS, which in turn affects the P/E ratio and other per-share metrics. That’s why it’s essential to be aware of the difference between basic and diluted EPS (and other similar per-share metrics) and to be informed about any outstanding dilutive securities.

In summary, while the aggregate approach provides a simpler and more holistic view of a company’s valuation, per-share metrics offer granularity and additional perspectives. Both have their uses, and being aware of their nuances is key to making informed investment decisions.

You:

yeah i’m just not getting why P/E is the most used metric to evaluate company value, especially nowadays we can buy fraction of shares, (opposed to purchasing # of shares) and totallly undestand share-centric gives very important perspectives as well. (just for company valuation i think aggregate method seems better)

ChatGPT:

Your skepticism is shared by many analysts and investors, and there’s merit to your argument. The widespread use of the P/E ratio as a primary valuation metric has historical roots, conventions, and some practical reasons:

• Historical Convention: Historically, when stock markets first emerged, investors bought shares in whole numbers. Thus, understanding how much one is paying for the earnings of each share made intuitive sense. This convention persisted even as markets evolved.
• Simplicity: The P/E ratio is straightforward. Price and earnings are two of the most easily understood and accessible metrics for both seasoned investors and novices. Its simplicity likely contributed to its widespread adoption.
• Benchmarking: P/E offers an easy way to compare different companies in the same sector or industry. Even if you’re not strictly looking at it from a “per share” perspective, the relative P/E of companies can help identify which ones are potentially overvalued or undervalued in relation to their peers.
• Media and Communication: It’s a metric that’s easy to communicate. When financial news discusses valuations, they often gravitate toward easy-to-understand metrics like P/E. Over time, this has reinforced its use among the broader investing public.
• Granularity: While the aggregate method provides a holistic view, the P/E ratio (being share-centric) can capture nuances like potential dilution, which the aggregate method might gloss over unless specifically accounted for.
• Behavioral Finance: From a behavioral standpoint, people like to think in terms of tangible units, like “a share.” Thus, understanding the earnings and price of that tangible unit feels more direct.

However, the financial world is vast, and many seasoned investors and analysts don’t rely solely on the P/E ratio. They use a multitude of metrics like Price-to-Book, Price-to-Sales, EV/EBITDA, and more. They also employ comprehensive valuation methods like discounted cash flow analysis, which doesn’t hinge on per-share metrics.

The advent of fractional shares, as you pointed out, does challenge the traditional reliance on per-share metrics for individual investors. As investment technologies and platforms evolve, it’s possible that the emphasis on specific metrics might shift.

In essence, while the P/E ratio remains a widely used and easily communicable metric, it’s just one tool among many. As with any tool, its utility depends on the context and the specific questions one is trying to answer. Your inclination toward an aggregate approach is entirely valid, especially in today’s evolving investment landscape.