Investing Club Mailbag: How to avoid pitfalls when calculating stocks' price-to-earnings multiples

Published Thu, Jan 12 20236:00 AM EST

On the January 5 th , 2023 Morning Meeting, you talked about stocks that had high P/E's being too expensive and cited an example. You then promoted STZ as a "buy." Isn't the P/E extremely high? My research says its P/E (not Forward P/E) is around 500. Is my resource wrong? -Bill How to calculate price-to-earnings multiples We have seen this and similar matters come up previously. So, Bill's question provides us with the perfect opportunity to address an issue when it comes to figuring out stock multiples: Make sure you are using the earnings number that everybody else is using. Data providers that automatically pull from companies' quarterly releases in calculating trailing price-to-earnings (P/E) sometimes bring in numbers that are not the ones used by Wall Street. It's not technically wrong but it may prevent you from being on the same page as everyone else when analyzing the stock. There are tons of financial metrics that investors should consider when evaluating companies. However, for trailing P/E purposes, the adjusted earnings-per-share number is usually the one to use. When provided, this adjusted number — also referred to as comparable in the case of beer, wine and spirits giant Constellation Brands (STZ) — is the headline EPS you see reported on CNBC and elsewhere that's compared to analyst estimates. It strips out one-time items including charges and gains and provides a look at the fundamentals, which can be compared to previous quarters. The one-time items are just that, they can change from quarter to quarter or not occur at all. It's worth noting that many investors, including us, tend to use forward P/Es, which use the next 12 months' earnings estimates, rather than the trailing 12 months of actual results when looking at a stock's valuation multiple. If we look at FactSet, one of our main data providers, we see a sky-high multiple on a trailing basis for Constellation Brands. Clearly, there's a discrepancy between what the rest of the Street and the Club are using in our calculations and what FactSet — and perhaps Bill's data provider — has auto-populated to determine that multiple. In the past four earnings statements — trailing multiples use the four most recent quarterly reports — the multiple on the reported numbers at Constellation (again, not the adjusted or comparable numbers) appears to be even higher than the P/E that Bill indicated in his question: nearly 630 on an STZ stock price of $220. That's because it includes a heavy loss in fiscal 2023 second quarter, which was caused by a large impairment charge. The adjusted EPS numbers for the fiscal second quarter take out that roughly $1.06 billion impairment charge relating to Constellation's stake in cannabis company Canopy Growth (CGC). That along with a few other adjustments — outlined in the company's 10-Q — bring the reported EPS for the fiscal second quarter from a $6.30 per share loss to an adjusted profit of $3.17 per share. Using Constellation's adjusted numbers, which not only change the fiscal second quarter but all four quarters, the trailing P/E is nearly 20 — only slightly higher than the trailing multiple for the S & P 500 . Whether you agree or disagree with excluding one-time items is up to you. The need to take an impairment like this is directly tied to prior decisions made by management, which is a factor worth considering. In Constellation's case, we were happy to see management do away with the dual-class share structure as it prevents shareholders with outsized voting rights from pushing through unfavorable deals. We do factor that impairment charge into our thinking. But we're less concerned with it, given that it is non-recurring — and more importantly, is addressed by the removal of the dual-class share structure going forward. When Jim Cramer refers to high-multiple stocks, he's talking about ones that trade much higher than the S & P 500 — and especially, those with earnings more at risk in a troublesome macro environment. Based on the Club's faith in Constellation as a recession-resistant stock — people don't tend to stop drinking alcohol no matter the economic climate — and a multiple relatively in line with the market, we view STZ as a buy, which is indicated by our 1 rating on the stock. Bottom line In addition to calculating the multiples on your own to ensure that you are indeed looking at what everyone else is looking at, be mindful that expectations of future performance are going to help determine a possible stock price much more so than past performance. That's why instead of using trailing earnings as our yardstick, we use forward earnings expectations. Nobody can predict the future. It's also why portfolio managers always want to pay close attention to companies' guidance and what's said on post-earnings conference calls. Both are good sources of management insight into the current operating environment and expectations for future quarters. (Jim Cramer's Charitable Trust is long STZ. See here for a full list of the stocks.) As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. Jim waits 45 minutes after sending a trade alert before buying or selling a stock in his charitable trust's portfolio. If Jim has talked about a stock on CNBC TV, he waits 72 hours after issuing the trade alert before executing the trade. THE ABOVE INVESTING CLUB INFORMATION IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY , TOGETHER WITH OUR DISCLAIMER . 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Constellation Brands' Corona Light is displayed for sale at a grocery store in New York.

Scott Eells | Bloomberg| Getty Images

On the January 5^th, 2023 Morning Meeting, you talked about stocks that had high P/E's being too expensive and cited an example. You then promoted STZ as a "buy."