Why P/E Ratios Can Be Misleading

I write a lot about stock valuation metrics. One thing to get across is that it’s important to look at everything but worship nothing. Every financial stat can be misleading.

In the Wall Street Journal, Mark Hulbert look at the famous Price/Earnings Ratio:

Consider the S&P 500’s current P/E based on trailing earnings. For the four quarters through June 30, the index’s earnings per share amounted to $91.13, according to S&P Dow Jones Indices. That translates into a P/E ratio of 18.2, which is higher than 79% of comparable readings since 1871, according to a database maintained by Yale University professor Robert Shiller.

Many bulls try to wriggle out from this bearish sign by focusing on estimated earnings.

According to FactSet Data Systems, the consensus forecast from Wall Street analysts is that earnings from companies in the S&P 500 will be $122.01 a share next year, which translates into a P/E ratio of 13.6. That is 6% less than the 14.5 median of historical P/Es in Mr. Shiller’s database.

There is a catch: Forward-looking P/Es are almost always lower than those based on trailing earnings—often much lower. There are at least three reasons why, says Anne Casscells, a managing partner at Aetos Capital, which runs several hedge funds. First, corporate earnings usually rise from one year to the next. In addition, analysts’ estimates focus on what’s known as “operating earnings,” a looser category than the actual reported earnings used to calculate the average of past P/Es.

And last but not least: Wall Street analysts’ predictions tend to be way too optimistic.

A few years ago, I touched on another problem inherent in the P/E Ratio:

We have to remember that the P/E Ratio is an unusual statistic because it looks at the relationship between two different kinds of the numbers. A stock’s price is a fixed-point number, which means you know exactly what a price is at any given time, but earnings is a rate, meaning it must be defined at something that only exists between two certain points in time.

There’s nothing inherently wrong about combining two different kinds of numbers though we should be bear in mind its limitations and this is one such time.

Posted by on August 19th, 2013 at 11:31 am


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