Can Investors Trust The P/E Ratio?
Few stock market metrics have cycled in and out of favor as often or as severely as the P/E ratio. Initially popularized by the legendary value investor Benjamin Graham (one of Warren Buffetts mentors), price/earnings ratios are used to assess the relative attractiveness of a potential investment. But these days, analysts are increasingly noting the P/E ratios flaws. Read on to find out what they are and what you can do to make sure youre doing a sound analaysis.
Whats a Good P/E Ratio?
In his book Security Analysis , Graham suggests that a P/E ratio of 16 is as high a price as can be paid in an investment purchase in common stock.
This does not mean that all common stocks with the same average earnings should have the same value, Graham explained. The common-stock investor will properly accord a more liberal valuation to those which have current earnings above the average, or which may reasonably be considered to possess better than average prospects.
Graham was also aware that different industries trade at different multiples based on their real or perceived growth potential. To the fabled investor, P/E ratios were not an absolute measure of value but, rather, a means of establishing a moderate upper limit that he felt was crucial in order to stay within the bounds of conservative valuation.
How the P/E Has Changed Over Time
Of course, this moderate upper limit was all but abandoned some 20 years after Grahams death, when investors flocked to buy any issue ending in com. Some of these companies sported P/E ratios best expressed in scientific notation. Even before the dotcom madness, however, there were those who felt that comparing a stocks price to its earnings was shortsighted at best, and pointless at worst.
The Contrarian View to the P/E
William J. ONeill, the founder of Investors Business Daily, asserts in How to Make Money in Stocks that contrary to most investors beliefs, P/E ratios were not a relevant factor in price movement.
To demonstrate his point, ONeill pointed to research conducted from 1953 to 1988 that showed the average P/E ratio for the best-performing stocks just prior to their equity explosion was 20, while the Dows P/E ratio for the same period averaged 15. In other words, by Grahams standards, these soon-to-be-superstar stocks were overvalued. (For related reading, see Cheap Stocks Can Be Deceiving.)
Does P/E Revert to Industry Norms?
Now, in theory, stocks that trade at high multiples will eventually revert back to the industry norm - and vice-versa for those issues sporting lower earnings-based valuations. Yet, at various points in history, there have been major discrepancies between theory and practice, with high P/E stocks continuing to soar while their cheaper counterparts stayed grounded, just as ONeill observed. On the other hand, the reverse has held true during other time intervals as well, and we cannot discredit Ben Grahams investment process either.
Whats more, over the last 20 years, there has been a gradual increase in P/E ratios as a whole, despite the fact that the stock market has been no more volatile than in years past. Using data presented by Yale University Professor Robert Shiller in his book Irrational Exuberance (first published in 2000), one finds that the price-earnings ratio for the S&P 500 Index reached historic highs toward the end of 2008 through the third quarter of 2009. Yet the index posted a remarkable 38% gain following the recession lows, despite abnormally high investment ratios.
Years Median P/E Ratio
1900-1910 13.4
1911-1920 10.0
1921-1930 12.8
1931-1940 16.2
1941-1950 9.5
1951-1960 12.6
1961-1970 17.7
1971-1980 10.4
1981-1990 12.4
1991-2000 22.6
2001-2010 22.4
Table: S&P 500 Index Median P/E Ratios
Source: Schiller, Robert. Irrational Exuberance [Princeton University Press 2000, Broadway Books 2001, 2nd ed., 2005]
Can the P/E Ratio Be Rescued?
So does this mean that ONeill is right and P/E ratios have no predictive value? Or that, in todays technology-driven economy, the ratios have become passe? Well, not necessarily. The key to effectively using P/E ratios, many experts claim, is to exam them over longer periods of time, while integrating forward-looking data like earnings estimates and the overall economic climate into the analysis.
One way of accomplishing this is through the use of PEG ratios. Made fashionable by famed money manager Peter Lynch, PEG ratios are similar to P/E ratios, but the ratio is divided by annual EPS growth to standardize the metric. Such a procedure is implemented because higher growth prospects justify a higher P/E ratio. In One Up on Wall Street, Lynch wrote, the P/E ratio of any company thats fairly priced will equal its growth rate. (If these numbers have you in the dark, these easy calculations should help light the way. Check out How To Find P/E And PEG Ratios.)
The World Without P/E
With that in mind, it is, perhaps, easier to understand why some investors virtually ignored earnings - or the lack thereof - altogether while gobbling up shares of the latest cyberspace sensation in the late 90s. Nonetheless, the question remains: Are P/E ratios still a valuable tool in making investment decisions or have they gone the way of the dodo bird?
Ben Levisohn, a financial journalist, believes it is the latter.
What is wrong with the P/E? He asks in the Wall Street Journal. In short, the e cant be trusted.
Levisohn notes that P/E ratios have generally declined during times of economic uncertainty and that thanks to the recent shift toward rapid-fire stock trading , the P/E ratio may be losing its relevance.
The emergence of exchange-traded funds in the past 10 years has allowed investors to make broad bets on entire baskets of stocks. And the ascendance of computer-driven trading is making macroeconomic data and trading patterns more important drivers of market action than fundamental analysis of individual companies, even during periods of relative calm, Levisohn argues.
Fundamental Analysts Still Like P/E
Others, especially those who follow a rigorous fundamental analysis approach to investing, disagree, citing the popping of the tech bubble as a prime example of the sticky mess investors can find themselves in when they dont take heed of earnings and price.
Still, some general observations in order:
1. It is best to compare P/E ratios within a specific industry. This helps to ensure that the price-earnings performance is not simply a product of the stocks environment.
2. Be wary of stocks sporting high P/E ratios during an economic boom. The old saying that a rising tide lifts all boats definitely applies to stocks - even many bad ones - so it is wise to be suspicious of any upward price movement that isnt supported by some logical, underlying reason outside of the general economic climate.
3. Be equally dubious of stocks with low P/E ratios that appear to be waning in prestige or relevance. In recent years, investors have seen a number of formerly solid companies hit the skids. In these instances, it is foolish to think that the price will magically increase to match the earnings and boost the stocks P/E ratio to a level consistent with the industry norm. It is far more likely that any P/E increase will be the direct result of eroding earnings, which isnt exactly the P/E bounce bullish investors are looking for.
Bottom Line
In closing, while investors are probably wise to be wary of P/E ratios, it is, perhaps, equally prudent to keep that apprehension in context. While P/E ratios are not the magical prognostic tool some once thought they were, they can still be valuable when used in the proper manner. (Make an informed decision about your investments with these easy equations.
