We were recently asked the following excellent question from a subscriber and feel it provided the opportunity to share some helpful hints and insights into how to best utilize FAST Graphs:
“Usually, I think I understand that the orange P/E ratio line is an average of some type and it usually intuitively makes sense. However, for some stocks like CUBI the orange P/E ratio line for all the 9 available years is 28.9 However, I don’t think the actual price line has ever had a P/E above 17 and the normal P/E is 13.1. Don’t have to get into too many details, but what is another factor might be taking the orange P/E to 28.9? Not challenging the line, just trying to understand what other factors are in play.”
With the above question facilitates is an opportunity to provide an illustration into how FAST Graphs are an analytical “tool to think with.” Moreover, we believe it offers the opportunity to further illustrate how statistics can be misleading even when they are technically correct. Therefore, we present this short video with the objective of clarifying how to best utilize our tool.
Summary and Conclusions
In closing, we also include the following written explanation that we sent to the subscriber in answer to the question:
“Thanks for the question regarding the P/E ratio calculation for CUBI. There are several things that you need to consider when evaluating stocks utilizing FAST Graphs. First of all, always remember that this is an analytical “tool to think with.” Therefore, the first place you should check when you see anomalous looking valuation references – as you do with CUBI – is the company’s earnings growth rates (Chg/Yr) at the bottom of the graph. In this example you will notice that 2012’s earnings grew by 349% which is clearly an aberration.
Therefore, my first suggestion would be to draw the graph as an 8 year graph and take out that aberrant number. Once you’ve done this, you will discover that the orange P/E ratio line adjusts to a more rational P/E ratio of 15. This happens because the operating earnings growth rate drops to 10.3% when you take out that outlier number and therefore FAST Graphs applies the GDF…P/E=G formula which is an extrapolation between the Graham Dodd formula (GDF) and the P/E equal to earnings growth rate (P/E=G) which applies to all earnings growth rates between 5% and 15% growth.
Furthermore, when growth is above 15%, as it is when you run the “all” graph timeframe, with the aberrant number (349%) included in the average, the earnings growth rate balloons to 28.9%. Therefore, FAST Graphs automatically applies the P/E = growth rate (P/E=G) and draws the orange line as a P/E ratio of 28.9. However, that is clearly not a representative earnings growth rate for the company over all the other years.
Regarding the normal P/E ratio, its purpose as an additional valuation reference line is to provide insights into how the market actually values a stock in real world conditions. However, you should also keep in mind that both the orange valuation reference line and the blue normal P/E ratio valuation reference lines should actually be thought of as ranges rather than precise calculations. In other words, they are provided as an analytical reference. Consequently, a normal P/E ratio of 13.4 might be thought of as something like 13 to 14, and a P/E ratio of 15 might be thought of as 14 to 16. But the key is to examine the earnings and price relationships as they apply to either of those lines. FAST Graphs are analytical tools to think with, and they are dynamic which is one of the greatest attributes, in my humble opinion.
In the case of CUBI, once you take out the aberrant number it should be clear that the market has historically valued the stock in most cases at P/E ratios between 13 and 15. And finally, you should also consider that historical graphs provide insights into the past, but buy, sell or hold decisions should be made utilizing the forecasting calculators. In the case of CUBI you might look at the “Estimates” calculator as a moderately aggressive case, and the “Normal Multiple” calculator as a conservative case when running future rate of return calculations utilizing these aspects of our tool.
Regards,
Chuck”