The p/e conspiracy (price-earnings ratio)

The price-earnings ratio (p/e ratio) is one of the most popular metrics. Therefore, it seems surprising to claim that the general calculation of the p/e ratio on most financial platforms is questionable – not to say wrong. Using Apple as an example, I show common systematic errors of the calculation of the p/e ratio.

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How most financial websites calculate the p/e ratio

The p/e ratio is generally calculated for a business year of a company by dividing the last stock price of the calendar year by the earnings of the business year. In the case of Apple (AAPL), most data providers calculate the p/e ratio for 2018 as shown below:

Apple (AAPL) price earnings ratio calculation using the standard method

Apple’s business year ended 30th of September 2018 with earnings per share of USD 11.91 (1). For the calculation of the p/e ratio, however, the stock price of December 31, 2018 is used (2), although this is 3 months outside the business year’s end. The calculated p/e ratio is 13.23 (3).

It can be seen with the naked eye that the price at the end of 2018 (2) is well below the average price during Apple’s business year 2018 for which the p/e ratio is calculated.

In fact, this type of calculation involves two systematic flaws because:

1. For companies with a business year not equal to the calendar year, the stock price is outside the business year. For Microsoft (MSFT), the business year ends in June. In this case, the stock price and business year end are 6 months apart.
2. During a single business year, around 250 end-of-day stock prices exist. It doesn’t make sense to ignore all but a single stock price to calculate an “annual p/e ratio”. Doing so makes the p/e ratio highly dependent on the stock price of a single day. As a result, if there was a year-end rally and the stock market reach high levels at the end of December, the p/e ratios of all stocks are high. If the stock prices went down in December, the p/e ratios of all for that year are low. Regardless what happened during the remainder of the year.

An alternative method of the p/e ratio calculation

It makes sense to calculate the p/e ratio by respecting all stock prices of the company’s business year. This gives you an average stock price and allows you to calculation Apple’s p/e using an alternative method:

Apple (AAPL) price earnings ratio calculation using the alternative method

The average stock price, taking all stock prices into account, was USD 182.28, well above the USD 157.68 mark. Accordingly, the p/e ratio is higher at 15.3 compared to 13.2. This p/e ratio is much more representative for the valuation of Apple’s during its business year.

Conclusion

The questionable calculation of the p/e ratio also concerns related ratios such as the price/book ratio, etc. At the same time, this simple example shows that in the investment industry many things are taken for granted that should be open to discussion.

On DividendStocks.Cash the p/e ratio is calculated using the alternative method. Apple’s p/e ratio 2018 is therefore 15.3:

Apple (AAPL) price earnings ratios as seen on DividendStocks.Cash