Fuzzy math

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The Problems With P/E Ratios

I received a good question from a reader named Lauretta this week, and I decided to post my response here for other stock market investors.

The crux of her question is whether stocks with a low price-to-earnings ratio are safer if the market is headed for trouble, and whether stocks with a high earnings multiple are set for a bigger crash because they are theoretically overbought.

It’s a common, but pernicious idea: that a low P/E is inherently good and a high P/E is inherently bad. And while I think there is indeed great value in looking at earnings multiples and doing fundamental analysis, it is only part of the story a stock has to tell. The whole story is much more complicated than “low is good, high is bad.”

Earnings Targets Are Notoriously Wrong

Here’s my first point: A forward P/E is based on forecasts for earnings that are often more than 12 months down the road. That’s inherently a guessing game because of how much can change for the broader economy, a specific sector or an individual company.

Furthermore, let’s not mince words: Wall Street “experts” are frequently very friendly with the companies they cover, and they see things with rose-colored glasses. These well-paid analysts take CEOs at their word and try to avoid making enemies of multibillion-dollar corporations that could bring other business like a bond offering to their investment bank.

Consider that right now, there is serious concern that overall S&P 500 earnings estimates are way too high. And as Eddy Elfenbein points out at Crossing Wall Street, recent history shows that estimates have a decidedly downward drift to them over time.

So before you cling to those earnings multiples, keep in mind that the foundation of your math could be shaky.

Numerator Vs. Denominator

At risk of stating the obvious, the natural next step once you realize that earnings are fluid is admitting that price-to-earnings ratios do not have to “resolve” through price changes. Consider these examples:

  • Stock ABC is undergoing a painful reorganization — some think it has turned a corner and others are very unsure. So ABC trades for $10 a share on forecasts of $2 a share in FY2014 earnings — a forward P/E ratio of just 5. A bullish investor expects the share price to double to $20 ($20 divided by $2 in earnings is a P/E of 10). A bearish investor expects the earnings to drop big-time ($10 divided by $1 in earnings is also a P/E of 10).
  • Stock XYZ is on a tear and trades for $100 on forecasts of $2 in earnings. XYZ has a P/E ratio of 50. Some expect the run to continue, others think it is overbought. A bullish investor expects earnings to double ($100 divided by $4 in earnings is a P/E of 25). A bearish investor expects the earnings to flatline and the price to come back to earth ($50 divided by $2 in earnings is also a P/E of 25).

As you can see, the math works in all of these cases.

Oh yeah, and what about a company like Tesla Motors (NASDAQ:TSLA), which didn’t even have a P/E ratio since its earnings were negative until very recently. Clearly the big pop in TSLA stock shows that a stock without any earnings can still deliver gains … so why worship the E?

What Is ‘Fairly Valued?’

And now the stickiest point of all: Even if you can be 100% certain of earnings targets, you can never be 100% certain of what the “fair value” is for a stock’s earnings multiple.

All earnings are not created equal, and some stocks with volatile earnings or high growth can see P/Es that might seem way outside the norm for the rest of the market. But that doesn’t necessarily mean they are unfair.

Also, some industries trade for persistently low P/E ratios and others trade for high ones based on the nature of their business and overall market sentiment.

And last but not least, overall valuation for the entire stock market can differ greatly based on macro concerns.

Consider this crazy look at the entire history of the S&P’s P/E ratio. Not only is the range worth noting, but also some of the periods where the market looked incorrectly cheap (a period of single digits in the 1970s where the market went nowhere for almost a decade) or incorrectly expensive (the record high in May 2009 was actually the buying opportunity of a lifetime).

PE History

To wit: There is no universal price-to-earnings ratio metric that is fair — with buys always below and sells always above.

Consider banks. In 2009, they traded for very low P/E ratios, often in the ballpark of 5 or 6. But was Citigroup (NYSE:C) or Bank of America (NYSE:BAC) cheap? No, they were valued on the expectation that their earnings would collapse — “resolving” the low P/E ratios by changing the denominator instead of the numerator in that equation. Furthermore, we couldn’t even be sure that the earnings were real and sustainable. So both bank stocks lost ground significantly from late 2009 through the end of 2011 as Wall Street was reluctant to treat future earnings targets as reliable.

In short, a relatively low P/E vs. the broader market was seen as “fairly valued” for banks because of specific concerns about these stocks.

On the other hand, you have Amazon.com (NASDAQ:AMZN) that regularly trades for triple-digit P/E’s but keeps going up. When Amazon was barely break-even on aggressive Kindle pricing, investors were willing to be patient. They had faith in CEO Jeff Bezos, in the reach of Amazon paying off down the road and that continued growth in both the top line and bottom line were ahead. That trade proved very popular indeed despite the relatively high earnings multiple, and AMZN stock is up about 35% in the last 12 months to roughly triple the market.

In short, a relatively high P/E was seen as “fairly valued” for Amazon because of specific optimism for AMZN.

One Tool Among Many

This is probably more information than anyone needs, but it’s worth sharing because there is a host of misconceptions about P/E ratios.

Some latch on to the shortcomings regarding fuzzy forward earnings and a lack of clarity on fair value as reasons to completely ignore earnings multiples. Others believe that profits are the only thing that really matter on Wall Street in the long run, and that you can’t accurately value a stock without seeing how it’s trading based on those future profits.

As with all things, I am more circumspect. I think there are many ways that “cheap” valuations and “expensive” valuations can mislead you, but P/E ratios are always worth checking out for a general measure of sentiment on a stock.

I never buy a stock without checking earnings multiples … but it’s just one tool in my toolbox. I try to arm myself with all the information and make an informed decision based on the body of research I’ve compiled.

P/E is a tool that I use regularly but not independently of technical analysis, fundamental analysis and a broad look at headline risk for the specific stock and the market at large.

I’d advise everyone to use it the same way, with a healthy dose of perspective.

Have questions on P/E or anything else? Drop me a line at editor@investorplace.com.

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Jeff Reeves is the editor of InvestorPlace.com and the author of “The Frugal Investor’s Guide to Finding Great Stocks.” Write him at editor@investorplace.com or follow him on Twitter via @JeffReevesIP. As of this writing he did not own a position in any of the stocks named here.

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