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P/E RATIOS FOR DUMMIES: WHAT YOU NEED TO KNOW ABOUT P/E

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May 05, 2014 – Comments (1) | RELATED TICKERS: YHOO , ALL , F

P/E RATIOS FOR DUMMIES:  WHAT YOU STILL NEED TO KNOW ABOUT P/E

In the early 90s and 00’s you couldn’t turn on the news without hearing investors rattling off P/E Ratios, but in today’s news you hardly hear a thing about them.  P/E Ratios are the price of a stock divided by the annual earnings that the company made per share of stock.  There are many versions of P/E Ratios, but the concept is simple:  If a P/E Ratio is 8 then the purchaser of a stock is paying 8$ for every dollar of earnings.   This allows a potential investor to compare the value of peer companies in similar sectors.

While P/E Ratios once were the theoretical golden rule for stocks, today’s investors have begun to leave the PE Ratio Doctrine behind in favor of other metrics.   As a young investor with a lifetime of compounding interest ahead of me, I want to know the good, the fad and the ugly.  What do we still need to know about P/E Ratios?  How can they help us be better investors?  

The Debate:

The “Traditional” outlook on P/E Ratios, quoted by Benjamin Graham (Warren Buffet’s Mentor) in the Intelligent Investor, has been to buy firms with PE Ratios close to 10.  He attests in his 1934 book Security Analysis that one should purchase a firm with a P/E no higher than 16.  In great contrast, William O’Neills the founder of “Investor’s Business Daily” wrote in his book How to Make Money in Stocks that nearly 20 is acceptable.  He concluded that the P/E Ratio for the best performing stocks just prior to their equity explosion was infact 20.  These incredible investments would have been overlooked by Graham.  What weaknesses does the P/E Ratio have that might mislead investors? 

Why PE Ratios sometimes Don’t Work:

 1) High Growth Firms:

The most commonly known reason to explain why a P/E Ratio could be misleading concerns firms with no or negative earnings.  Clearly a zero on top of the faction gives us an undefined number.  This, however, may not mean the company is a bad investment! In fact, if may mean it’s the perfect time to invest.  Startup firms, or any firms heavily investing in their future would have comparatively lower PE ratios because they are spending the cash that would otherwise be counted as “earnings”.

 2) High Press Firms:

Let’s explore a theoretical flaw in the P/E Ratio Doctrine.  If two equal companies with equal earnings have drastically different P/E Ratios, this doctrine would advice you to take the lower P/E Ratio.  However, a higher P/E may have been due to a surge in press about the company recently.  While this surge in press may have bolstered the stock, enough time hasn’t elapsed to see the growth in earnings.  In the digital era, where information is disseminated virally, big press can likely mean much bigger growth potential!   The concept of “equal companies” may not be as clearly cut as it once was. 

 3) Banks:

Motley Fool’s Matt Koppenheffer, star of the  “Where the Money is”  radio show and podcast, asserted this April that P/E Ratios are also misleading when it comes to banks.  In times of economic prosperity, banks show great profits and thus very low P/E Ratios.  This, however, may be indicative that a market correction (or sudden drop in the market) is looming.  His assertion assumes, as most rational investors do, that if the market is soaring, eventually it will loose steam.  Investors who buy when Bank P/E Ratios are low, are therefore buying at exactly the wrong time. 

So What Can we Learn from P/E Ratios? 

How do we reconcile these two viewpoints?   If P/E ratios can’t tell us the one thing we want to know (What and When to buy a stock) are they totally useless?  Absolutely not.   In fact, they are an excellent predictor of the market as a whole.

In Robert Shiller’s Irrational Exuberance he plots the Real P/E Ratio against the historic Interest Rates to assert that stock P/E ratios inevitably return to a “historic normal.” He believed that P/E Ratios of 20+ were too high and would necessarily mean the market would correct itself.

He then plots Price earnings against the twenty year returns that Investors received in the stock market.  He concludes that investors who commit their money to an investment for ten full years, do well when prices were low relative to earnings at the beginning of those ten years.  

With this philosophy, an enthusiastic investor lamenting that he missed the dotcom boom or the biotech bubble can be consoled knowing that they are nothing but bubbles and buyers in those markets are what Graham refers to as “speculators” and not true investors.   After all, he says, “the truly dreadful losses always occur after “the Buyer Forgot to ask ‘How much?’

 

 

Firms with Currently Low PE Ratios:  Courtesy of  TheOnlineInvestor.com

List of Low PE Ratio Stocks in this Slideshow:

 

Company                                 Ticker    PE Ratio

American International Group Inc        AIG       2.55

Ford Motor Co. (DE)                     F         3.01

Seagate Technology Plc                  STX       5.16

Cliffs Natural Resources, Inc.          CLF       5.71

Assurant Inc                            AIZ       5.89

Apollo Education Group, Inc.            APOL      6.00

Western Digital Corp.                   WDC       6.34

Yahoo! Inc.                             YHOO      6.45

Western Union Co.                       WU        7.13

ConocoPhillips                          COP       7.60

Pitney Bowes Inc                        PBI       7.63

CF Industries Holdings Inc              CF        7.93

Peabody Energy Corp                     BTU       8.13

MetroPCS Communications Inc             PCS       8.19

AFLAC Inc.                              AFL       8.21

Abbott Laboratories                     ABT       8.37

SLM Corp.                               SLM       8.46

Northrop Grumman Corp                   NOC       8.58

Joy Global Inc                          JOY       8.65

WellPoint Inc                           WLP       8.65

Allstate Corp.                          ALL       8.67

Horton (D.R.) Inc.                      DHI       8.68

Discover Financial Services             DFS       8.85

Xerox Corp                              XRX       8.94

L-3 Communications Holdings, Inc.       LLL       8.95

 

1 Comments – Post Your Own

#1) On May 05, 2014 at 7:41 PM, TSIF (99.96) wrote:

Nice summary, No 1 has a sentence that I'm either mis-reading or got out of context.

 "Startup firms, or any firms heavily investing in their future would have comparatively lower PE ratios because they are spending the cash that would otherwise be counted as “earnings”.

 s/b:   have N/A or comparatively HIGHER PE ratios...

These are very tricky to value, those near break even can have large share movements, but I agree, the high P/E should not be used as a first indicator to run.

Regarding 2, High Press firms, not so sure there is as much of that, analysts seem to help, but there are High Press firms based on who the analyst is, such as Crammer who can often swing a stock.

As you note, you need to compare P/E within a sector. International stocks can also be much lower, indicating risk.

I don't like many metrics on banks, the debt quality, reserves, and other valuation metrics can skew data. 

Good luck.  

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