This article is not about sense or none-sense of applying the p/e ratio (price-earnings-ratio) for valuations. It’s about the hidden fact that most of the financial industry calculates this metric wrong. It will show this using Apple (AAPL) as an example.
Usually, the p/e ratio is based on the calendar year and calculated using the stock’s price at year end divided by the earnings of the business year. Morningstar calculates the p/e ratio 2017 for Apple as shown in the picture below:
Apple’s business year 2017 ended on September 30th, 2017 with earnings per share of 9.21 USD (1). Yet, the stock price used for the calculation of the p/r ratio is taken from December 31 th,2017 (2) – three months after the business year ended.
Yet, the stock’s price on year end was higher than on any day during the business year. This kind of calculation has two systematic flaws:
It’s much better to determine the p/e ratio by calculating an average price based on all closing prices of the company’s business year. Doing so, the calculation of the p/e ratio 2017 for Apple looks like this:
The average stock price during the business year 2017 is 137.06 USD. Far below 169.23 USD at the end of 2017. Accordingly, the new p/e ratio is 14.88 instead of 18.37. The supposed calendar year p/e ratio became a business year p/e ratio.
Debating about the calculation of the p/e ratio is not purely academic but impacts our understanding of valuation.
According to Morningstar’s P/E ratios, Apple’s current P/E ratio of 18.36 seems to be in-line with 18.37 in 2017. Yet, we have seen that 18.37 is based on a single stock price, three months after the business year ended, and exactly when it reached a new all-time-high.
In my understanding, 18.37 is not representative for 2017. In contrast, 14.88 is a more accurate number, because is respects the average valuation of Apple during the business year. In this regard, instead of staying on the same valuation level, Apple became clearly more expensive.
Thus, by applying correct p/e-ratios may draw a completely different picture of the valuation. In case of Apple, the p/e-ratio of 14.88 in 2017 represented a slight over-valuation compared to the 10-year p/e-ratio. Today, a slight over-valuation became a significant one, which is in stark contrast to what Morningstar and other financial data providers show.
Using Apple as an example, I showed that the widely used p/e-ratio calculation is flawed and valuation results may greatly differ if the real pricing level of the stock during the business year is considered instead a single price possibly months outside the business year.