Note: Effective November 30, 2005, we will make a slight change to the methodology for calculating trailing-12-month (TTM) price-to-earnings, price-to-book, price-to-sales, and price-to-cash-flow for funds and other portfolios. We will now use a harmonic weighted average, rather than an arithmetic weighted average. The harmonic method prevents outliers from skewing the result, and it is consistent with our existing methods for calculating prospective price ratios. This change will not impact the Morningstar Style Box assignments for portfolios.
The weighted average of the price/earnings ratios of the stocks in a fund’s portfolio. The P/E ratio of a stock is calculated by dividing the current price of the stock by its trailing 12 months’ earnings per share. In computing the average, Morningstar weights each portfolio holding by the percentage of equity assets it represents, so that larger positions have proportionately greater influence on the fund’s final P/E.
Benefits
A fund’s price/earnings ratio can act as a gauge of the fund’s investment strategy in the current market climate, and whether it has a value or growth orientation. Companies in those industries enjoying a surge of popularity (e.g.: telecommunications, biotechnology) tend to have high P/E ratios, reflecting a growth orientation. More staid industries, such as utilities and mining, tend to have low P/E ratios, reflecting a value orientation.
Origin
Morningstar generates this figure in-house, based on the most-recent portfolio holdings submitted by the fund and stock statistics gleaned from our internal U.S. equities databases. (Our U.S. equities department receives prices from ComStock, a division of Interactive Data Corporation. , and gathers earnings information from a company's most-recent annual and quarterly income statements.) Negative P/Es are not used, and any PE greater than 60 is capped at 60 in the calculation of the average.
For the Pros
Gauging P/E Ratios
The P/E ratio relates the price of the stock to the per-share earnings of the company. A high P/E generally indicates that the market will pay more to obtain the company because it has confidence in the company’s ability to increase its earnings. Conversely, a low P/E indicates that the market has less confidence that the company’s earnings will increase, and therefore will not pay as much for its stock. In most cases a fund with a high average P/E ratio has paid a premium for stocks that have a high potential for increased earnings. If the fund’s average P/E ratio is low, the manager may believe that the stocks have an overlooked or undervalued potential for appreciation.
A Question of Value
Occasionally a stock considered a value stock will be selling at a high price/earnings. This can happen because the company has very low earnings, and is trading on the basis of book value or cash flow. Consequently, an out of favor stock may trade at less than its book value, yet have such low earnings that the price looks high in contrast to earnings.