Are P-E's Past Their Prime?

Price-earnings ratios are one way investors determine whether equity prices are cheap, expensive, or fairly valued. But are they the best way to gauge stocks?

Getty Images

The price-earnings ratio is a popular tool for investors. But these days, as both prices and earnings fluctuate rapidly, the p-e tool is getting extra attention because it tries to answer a key question: With the broad Standard & Poor's 500-stock index down almost 20% from its October peak, are stocks cheap enough to make them a great bargain for long-term investors?

Fueling the debate over p-e's, the same stock can look cheap or expensive, depending on how the p-e ratio is determined. The p-e ratio is calculated by dividing a stock's price (or the value of an index) by its annual earnings. A high p-e can be a sign that a stock is either overvalued or poised for stellar growth. A low p-e can be a sign of a stock that is a good long-term value—or a sign of a company in trouble.

While a stock's price is easy to determine, earnings are harder to measure. Some investors prefer forward earnings, often determined by analyst estimates for earnings of the next 12 months. The problem is that analysts are often wrong, as they have been about financial stocks over the past year. "No one has a perfect crystal ball," says Brian Reynolds, chief market strategist at WJB Capital Group.

Is "E" Trustworthy?

For investors looking for more certainty, trailing earnings are preferred. This measure of earnings, often based on the past 12 months, has the disadvantage of looking backward while the stock market is often looking forward, trying to predict future trends. Trailing p-e's "won't tell you much about turning points," Reynolds says.

In either case, investors need to determine how much they trust the "e" in the p-e ratios.

Until a year ago, the market had learned to expect large earnings from financial stocks. Little did investors know how fragile those earnings were. With firms relying so much on subprime loans and other questionable debt, "those earnings have gone away forever," says John Merrill, chief investment officer at Tanglewood Capital Management in Houston. "You want to use [p-e ratios] as a starting point, but you want to use a little common sense on how sustainable those earnings are," he says.

The trailing p-e ratio for the S&P 500, which includes the first of the second-quarter earnings reports, is 16.4, according to Thomson Reuters (TRI). The forward p-e is 12.2. The average p-e since 1935 is 15.8, but stock valuations have been much higher in recent decades, with the average p-e above 20 in the past 25 years. That puts trailing p-e's in a gray area, not obviously cheap nor expensive. The forward p-e of 12.2, however, is cheap by most historical comparisons.

But that forward p-e includes some ambitious assumptions about where earnings are headed in the next year. After an expected 17.1% fall for earnings in the second quarter, Thomson Reuters says, analysts are predicting an earnings rebound of 12.7% in the third quarter, followed by a 61.5% jump in the fourth quarter, and increases above 30% in the first half of 2009.

Ashwani Kaul, director of research at Thomson Reuters, points out that these estimates assume a big rebound for financial earnings. "Maybe the banks have turned the corner," he says. Hopes were raised by better-than-expected second-quarter earnings from Citigroup (C), Wells Fargo (WFC), and JPMorgan Chase (JPM). However, "we're not as confident in the 'e' as we were just a year ago, because the analysts have been so wrong on their projections," Kaul says. That makes the stock market jittery despite the low forward p-e ratio.

A Good Screen?

With so many questions about the reliability of p-e ratios, there is naturally a lot of debate about how useful p-e's are to investors in picking stocks.

"I've never found p-e ratios to be a particularly good screen for me," says John Wilson, chief technical strategist at Morgan Keegan. After all, the stocks that do the best in the stock market are those that beat their earnings estimates, he says. Some of the best-performing stocks can have higher p-e ratios, reflecting their better growth prospects.

Brian Gendreau, investment strategist at ING Investment Management, says p-e ratios are "a very strong and powerful indicator." He adds, though, that p-e's are not a good way of predicting the near future. "Sometimes, the market is cheap because growth prospects are not very good," Gendreau says. "If valuations are inexpensive, they can stay that way for quite a while."

For example, energy stocks tend to have low p-e's—with the average under 10—because, despite rapid growth from this sector, most investors assume huge profits won't be sustainable when energy prices cool off.

"Just because something is cheap doesn't mean it's a bargain," Reynolds says.

Guiding the Long View

Still, p-e's can be a good guide for investors with a long time horizon. In the past, periods where stocks have low p-e's have been great times to invest, as long as you're not eager for quick returns.

While valuations are cheap, the broader stock market's recent momentum is "dreadful," Gendreau says. But, he says, p-e's demonstrate that stocks should eventually recover—perhaps in a year to 18 months.

"If you've got a two- or three-year time horizon, this is an excellent time to buy," Merrill says.

The concern of many on Wall Street is what happens to prices, earnings, and p-e's over the next year. More financial troubles and an economic slowdown could prove that today's p-e ratios are appropriate or even overly optimistic. But for individual investors with the stomachs to handle a wild ride, p-e's say this might be a good time to buy.

Before it's here, it's on the Bloomberg Terminal. LEARN MORE