Fundamentals

# How to estimate future PE ratios

December 22, 2012

Much the same as future EPS growth, estimation of future PE ratios is an important skill to have in place as a value investor. A company’s price to earnings ratio (PE) is a relative measure of how expensive or cheap a company is – check out this primer explaining what factors affect PE and why it’s important. In this article we’ll look at a few different techniques to estimate future PE ratios.

Many companies typically has a default PE range that fall into. For most established healthy companies with an average earnings growth rate this PE ratio range usually lies between 10 – 20. For most investors, this is considered to be a reasonable multiple of earnings to pay for a typical company. This is far too broad a generalization however, as there are many factors that affect PE, including the industry the company belongs to, higher or lower earnings growth rates from the norm, and even macroeconomic factors.

## Using historical data

One of the most reliable ways to estimate future PE for a company is to look at its past to see what the typical range is and how it’s changed over time. Let’s look at some historical data from IBM. Historical PE ratios can be found on msn money as follows:

1. Go to the msn Money website.
2. Enter the ticker of the stock we are interested in
3. Click on Key Ratios in the menu bar on the left side of the screen
4. Click on 10-YR summary on the horizontal menu that appears (note that this is a different 10-YR summary to the one that’s listed in the green menu bar on the left side of the screen – confusing!)
5. Average PE ratios for each of the last 10 years are listed in the table

In this example it’s clear that IBM’s average PE has been declining over time. Back in 2002 – 2004 a typical PE for the company was in the 20’s. More recently IBM has been trading at a PE in the 11 – 15 range. For some purposes this may be the extent of the level of accuracy required. It may be sufficient to state that, “Recently IBM has been trading at a PE ratio of 11 – 15, therefore it’s estimated that this will continue for the near future.

Since we’ve got the technology available, let’s run some calculations to try to nail down an even more accurate prediction. First let’s input the data into a spreadsheet and calculate some more averages:

As expected, the average PE over the past five years is significantly less than for the past ten. When estimating future PE ratios, it’s normally best to give recent data a higher weight than more distant, particularly since as companies mature it is normal for growth to slow and for the PE to contract as a result. I would be comfortable estimating a future PE of 12.5 for the next five years based on the average over the previous five. This fits well within our intuitive first guess of between 11 – 15, and is also well within the guidelines of 10 – 20 for a mature, healthy company, which IBM most certainly is.

Let’s go just one more step however and see if there is any trend in PE over the recent past. If we plot the most recent five years of data in a scatter graph and apply a linear trend line we get the following:

There is a clear downtrend in the PE data. I have included the equation for the trend line – based on the slope, IBM’s PE is trending down at a rate of 0.44 per year. How can we use this information? If we want to attempt to estimate PE a fixed number of years in the future, we can simply use the equation. Let’s calculate what the predicted PE is in 3 years time (2014):

• PE = -0.44(2014) + 896.48
• PE = 10.32

An average PE of 10.32 may or may not be realistic in this case. One problem with this method is that the timeframe can’t be extended out indefinitely. In this case after just a few years the PE becomes an extremely low multiple of earnings, which while certainly possible, is not probable – at least from the information available to us.

It probably makes the most sense to look at the trend from a purely qualitative sense rather than strictly analytical. The investor might look at this and say, “IBM’s PE has averaged 12.5 over the past five years, and has been trending down slightly. A PE of 12 seems a reasonable estimate for the near future given this information.”

This is not an exact science, and it is important as value investor’s to apply an appropriate margin of safety to any calculations or valuations that use estimated data.