Many investors commonly misuse Price Earning (P/E) ratio during their analysis in determining fair value. Two years ago, we talked about the many common misuse of P/E ratio in stock analysis. Many common misuse of P/E ratio includes: Using trailing P/E, Neglecting earning growth, Ignoring one-time event, ignoring balance sheet and ignoring interest rate. Using trailing P/E in my opinion, is the most commonly abused feature of P/E ratio.
Suppose that a stock has earning per share (EPS) of $ 3.59 and share price is recently traded at $ 18.50 per share. That gives it a P/E of 5.15, which is a yearly return of ~ 20%. Considering that interest rate is around ~ 4.75%, this stock is a very undervalued stock, you say. Not so, if you found out that the forward EPS (meaning: EPS for the coming year) comes in at $ 0.75 per share. You do some checking and it turns out that the $ 3.59 EPS is earned during the past twelve months.
Using trailing EPS is very common for shares that has been hammered in recent months. For example, a company that has done fine in the past, suddenly found itself in trouble. As it discovers that it cannot earn as much as previously, the company reduced its EPS estimate for the coming months or years. As most investors are looking for future appreciation, they will be selling off the stocks that reduced its EPS going forward. Thus, you are in a situation where if you are not careful, you would perceive a stock to be undervalued by looking at its trailing P/E.
The stock in the preceding example turns out to be Countrywide Financial Corp. (CFC). This is a stock that is in the spotlight for its subprime mortgage exposures. Further, Countrywide has seek the help of a larger bank (Bank of America) to infuse $ 2 Billion or 15% stake in Countrywide to keep the bank afloat. That, I feel is a desperate attempt by Countrywide to get the necessary infusion. A string of bad news which didn’t shake Countrywide stocks were revealed when Countrywide announced that its September mortgage funding fell 44% from a year ago. The good news however, was that Countrywide has 90% of its total loans as conforming loans. Previously, that figure was 60% of total loans. Thus, this results in the decrease of overall loan volume. Announced previously, Countrywide would ax 12,000 jobs or 20% of its workforce due to the change of the way they originate loan.
Thus, while using trailing P/E ratio, Countrywide stock would appear undervalued. However, considering the underlying situation of its business, one would look at its forward EPS which is $ 0.75 per share. Looking a P/E ratio this way, Countrywide stock does not look as appealing despite the fact that it may earn significantly higher EPS in the following years.