Can Traders Trust Stock P/E Ratios?

11/29/2010 11:44 am EST

Focus: STRATEGIES

By Derek Simon, contributor, Investopedia.com

Few stock market metrics have cycled in and out of favor as often or as severely as the price/earnings (P/E) ratio. Initially popularized by the legendary value investor Benjamin Graham (one of Warren Buffett's 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 ratio's flaws. Read on to find out what they are and what you can do to make sure you're doing a sound analysis. Buying at the right time is crucial, but how do we know when that is? Even traders who trade primarily using technical analysis can find value in fundamental figures like P/E ratios.

What's 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 Graham's 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 stock's price to its earnings was shortsighted at best, and pointless at worst.

The Contrarian View to the P/E

William J. O'Neill, the founder of Investor's 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, O'Neill 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 Dow's P/E ratio for the same period averaged 15. In other words, by Graham's 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 O'Neill observed. On the other hand, the reverse has held true during other time intervals as well, and we cannot discredit Ben Graham's investment process either.

What's 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.

chart
Click to Enlarge

NEXT: What Does the Future Hold for P/E Ratios?

|pagebreak|

Can the P/E Ratio Be Rescued? 

So does this mean that O'Neill is right and P/E ratios have no predictive value? Or that in today's technology-driven economy, the ratios have become passé? Well, not necessarily. The key to effectively using P/E ratios, many experts claim, is to examine 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 price-to-earnings-growth (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 earnings-per-share (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 that's fairly priced will equal its growth rate."

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' can't 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 ten 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 Ratios

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 don't 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 stock's environment.
  1. 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 isn't supported by some logical, underlying reason outside of the general economic climate.
  1. 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 stock's 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 isn't 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.

By Derek Simon, contributor, Investopedia.com

Related Articles on STRATEGIES