Friday, April 06, 2007

Forward PER

PER may be a simple concept but its application can actually be quite complicated. For those who need some refresher course on the PER, it is the Price Earnings Ratio of a stock. It tries to determine the cheapness of the stock by dividing the stock price by its earnings per share (or EPS). For more info, read this post.

Now the issue here, which have never really been discussed in detail in this blog all thanks to this blogger who conveniently left it out, is which EPS should we use to calculate PER? Is it the latest historical EPS announced by the co.? Or what?

The answer is the expected EPS in 1 yr's time (not announced by the co. yet, i.e. it is not in the annual report). The resultant PER is also called the forward PER. The reason is very simple. The stock market always look forward, not backward. It is the culmulation of the expectations of all the players in the market. Hence when using the expected EPS of the stock in 1 yr's time to calculated PER, we roughly get a good sense of the market's expectation of the value of the stock.

BTW, this expected EPS (also called the consensus EPS) is usually the average of all the sell-side analysts EPS estimates for the next year and this no. can be easily pulled off bloomberg or other financial information providers. Now of course you may argue, sell-side is good-for-nothing and their estimates are usually wrong. Then naturally you can do your own homework and come out with your own expected EPS in 1 yr's time and use that to calculate the stock's forward PER. Well that won't be too hard right?

Also, you may ask why 1 yr? Why not 2 yr or 10 yr? Well actually you can use any year you want, if you can forecast correctly the EPS of the stock in 10 yr's time. You should use that. For some business, you can, and you should. But when you are looking at a stock for the first time, it would be easier to get the consensus EPS estimate and get a rough sense of the stock's forward PER. As a rough gauge, I would consider anything less than PER 18x as cheap and I would not buy any stocks that is trading at more than PER 18x.

See also Price to book ratio
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