The P/E ratio (price to earnings) is used by most investors as a quick way to tell if a stock is "cheap" or expensive. It measures the price of the stock against the earnings of the last year (called the Trailing P/E) or it measures the price against the analysts' forecast for the next year (called the Forward P/E). Usually, the lower the number, the "cheaper" the stock. But that isn't always the case. In fact, a low P/E may be a signal that the stock will be cheaper, sooner.
Fundamental stock theory has it that the price of a stock is the present value of future earnings discounted to today. If that's true, then the lower the price is when compared to its earnings, the better off an investor should be. In other words, if a P/E is 5, then an investors would get their money back in 5 years. Peter Lynch of Fidelity Funds fame suggested that investors simply look at a P/E ratio and that's the number of years it will take to get their money back. When viewed in that perspective, a stock with a P/E above 20 or 30 becomes much less attractive. Conversely, a P/E of 5 or lower becomes very compelling.
But there's a catch. Earnings are a moving target. And analysts don't always predict the future correctly. In fact, there's a strong case to be made that they rarely do. But that's another topic. The message here is that while a P/E may be very enticing at the moment, it's only good for that time period. It's not going to stay there. Either the price will go up on good news or down on bad. And the lower the P/E ratio, the more likely the news will be negative. (For more investing ideas, see: www.theonlineinvestor.com)
Investors are a fairly smart lot. They anticipate the future. In fact, that's what investing is all about, not the past. That's why many stocks have low P/E ratios. Investors think the future isn't very promising. They see lower earnings ahead. When earnings go down, so do stock prices...and P/E ratios as well if the price goes down faster than the earnings.
Usually there are reasons for low P/E ratios, but they all come back to the effect any future events have on earnings. While some companies may show great earnings, their P/E ratio could still be very low. A good example used to be the auto companies. Many Wall Street analysts thought buying auto stocks when their P/E ratios were high and selling them when they were low was a good way to make money because the industry was so cyclical. When the ratios were very low (sometimes below 5) earnings were very strong, but when the economic cycle took its inevitable turn, consumers stopped buying cars, and earnings plummeted, sending stocks and ratios to very high levels.
Now it looks like banks are showing low P/E's. Investors don't believe they're out of the financial woods yet. They fear more regulations will hamper earnings. Or more bad loans are still to come. For whatever reasons, the basic message is the same: earnings won't be growing. They'll be slowing. It may be a good industry to find stocks with solid prospects that don't have a history of bad loans or won't be effected as much by new regulations. Some of these stocks may have a low P/E because they're in an industry that is out of favor, not because their earnings prospects are bad.
Of course, a P/E ratio is only one number. No one number can make the basis for a solid investment decision. But it can start investors down a path when the ratio is so low that they can't believe a stock could be selling that "cheap" (especially if it's low compared to what it used to be....see Microsoft (MSFT) as an example) . Like everything else in life, cheap is not always a good buy. Sometimes it's a reason to say good bye.
- Ted Allrich
April 10, 2012