QUESTION OF THE WEEK: DISCOVERING THE HISTORICAL PE

Determining the historical PE ratio for a business is a bit of an art.  Several of you have written in about it, but this email is getting right to a solution to the problem:

Question:

"Hi Phil...when calculating the average PE over a number of years, is it better to calculate using the standard Average calculation, or is it better to use a Mean calculation instead? I ask this because of the overinflated past PE numbers that resulted from the internet boom. These overinflated numbers sometimes occured once or twice over the past 10 year history. So does it really matter to include them in the overall calculation since they might overinflate the Average PE? I think the Mean calculation will smooth the Average out to a more reliable PE." 

-- Dennis and Lisa

Answer:

You know, these guys are already way better at this than I am.  What I usually do on MSN Money is just look at the PE bars year by year and make a reasonable assumption about what the future might hold based on that.

I sort of mentally toss out the really high PE years -- the ones that are way higher than the others. 

The idea is to guess what the PE could be if the business does what we think it will do.

We're going to use our best estimate of historical PE as a balance against the Rule #1 PE of 2X the estimated growth rate. 

The only time we're not going to use the Rule #1 PE is when the historical is LOWER. 

So when you look at Historical PE, look at it with that in mind -- that the only time to use it is when, for some reason, this business does NOT get the PE it should get. 

Find a reasonable Mean average or take the obvious visual high average (dumping the really high ones) and that's the historical PE for you. 

It's a rough guess.  Don't be too worked up about it.  Just be reasonable with the past.

Now go play!