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The Price is Right ... Right?

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May 1, 2014

Arguably the granddaddy of all the market metrics to determine expensive versus cheap, the price-to-earnings ratio has been (and probably always will be) a subject of hearty debate. Does P/E still matter? Yes, many experts say, but…

It starts with some simple math that surely a typical sixth-grader could handle. Take one number (the current price of a stock, in this case) and divide it by another (earnings per share for a full year). Voila, there’s your P/E ratio. Now go invest. If only it were that cut-and-dried. But it isn’t, and the subject is complicated by a myriad of other valuation models, financial media talking heads and everything else that swirls around an investor’s brain every day.

Whatever the case, understanding how P/Es work, and keeping your eyes open for the stories these numbers tell about a business or a market, are important for almost any investment or trading plan. Let’s break the discussion down.

Yes Kids, P/Es Still Matter

A stock price by itself doesn’t convey the entire picture. Just because XYZ Corp. is trading at $100 a share and ZYX Inc. is $10 doesn’t necessarily mean the former is a better investment offering strong growth prospects and astute management. Here, P/Es—along with other fundamental company information available through Trade Architect®—can offer valuable context (see figure 1).

If that $100 company earned, for example, $4 per share in the past year, that’s a P/E of 25—possibly “overvalued,” depending on, among other things, how that stacks up against industry peers. If other companies in the same industry have P/Es closer to 18 or 20, the $100 stock may be a bit expensive relative to its competitors and therefore have limited upside, or it may be poised for a decline. Beware.

FIGURE 1: CRUNCHING NUMBERS. Up-to-date P/E ratios (yellow arrows) are easily accessible through Trade Architect?just go to the Trade tab and enter the stock ticker. Source: TD Ameritrade. For illustrative purposes only.

By the same token, the $10 company that earned $1, for a P/E of 10, could be “undervalued,” meaning investors aren’t showing it enough love given its relatively healthy financial condition. A good rally prospect? So-called value stockpickers often hunt for low P/Es, along with other signs the shares may command a higher price.

P/Es can also be applied to the broader market, providing both history lessons and harbingers of potential turning points. Over the past three years, the trailing P/E for the Standard & Poor’s 500 Index averaged 16.3, according to S&P Dow Jones Indices, compared to its historical average around 15.

The market can spend long periods at high P/E levels before returning to historical norms. That’s what happened before and then after the dot-com bubble in the 1990s and early 2000s. Conversely, after the 2008 financial crisis, the market snapped back relatively quickly after sinking to the lowest P/Es in decades.

More recently, as U.S. stock benchmarks notched record highs, some P/E acolytes have sounded the “overbought/overvalued” alarm. At the end of March, the S&P 500 had a trailing P/E of about 17.8 and a forward P/E of about 15.5, near a seven-year high (see figure 2).

FIGURE 2: UPHILL CLIMB. Since bottoming around 10.5 in September 2011, the forward P/E for the S&P 500 Index has been on the rise, recently approaching a seven-year high at 15.5. Its also above the five- and 10- year averages (dotted lines). Source: FactSet Research Systems. For illustrative purposes only.

P/Es are So 20th Century

Over the past couple decades, those who would deign to dis P/Es gained ammunition as the Internet revolution gained momentum, altering perceptions on what should and shouldn’t be “valued.” Everyone was latching onto that “next big thing” where “eyeballs” and “page clicks” trumped good old-fashioned revenue growth and profit margins, or so it seemed.

To detractors, P/Es and other traditional valuation metrics are simply out of step with the modern digital era, failing to account for the rapid growth of many new technology companies. Indeed, a quick check of Trade Architect® reveals dozens of social media companies, online retailers and other similar names with P/Es well into the triple digits (see figure 3). Some even top 1,000.

FIGURE 3: HOW HIGH IS HIGH? The Stock Screener tab on Trade Architect? can provide a list of companies with triple-digit and higher P/Es (yellow box); still, such lofty numbers dont necessarily mean a stock is overvalued, or that it wont go higher.

Does that mean these stocks are overvalued? Not necessarily. In many cases, high P/E companies are accompanied by solid earnings and revenue growth and the promise of more for years to come (companies that are losing money don’t have a P/E, by the way).

“Some investors interpret valuation in a very narrow way through metrics like the price/earnings ratio,” Adam Levine-Weinberg wrote in December on The Motley Fool. In a narrow sense, P/E non-fans are correct that valuation “does not matter,” he said.

“A P/E ratio only takes into account a company’s current earnings and ignores the potential for long-term earnings growth,” Levine-Weinberg wrote. “If a business is likely to deliver exponential earnings growth for many years, a very high P/E ratio may be quite reasonable.”

Note also that P/E shouldn’t be shoehorned into all stocks and sectors arbitrarily without weighing other factors, such as how mature an industry is or the number of competitors. P/Es comparisons for online retailers may or may not be as useful as they are for, say, farm equipment manufacturers

What To Do?

Wherever you plant your flag in the P/E debate, there seems to be at least one common thread among many market watchers: You can’t disregard these numbers altogether.

Valuation “still matters (and always will),” as Levine-Weinberg stated in the headline of his article. Businesses exist to generate cold, hard profits, after all, and longer-term, the markets sort out who’s doing the best job at that, and who isn’t.

“I personally am still a fan of monitoring P/E ratios,” said Ryan Campbell, a Content Manager with Investools®, an education affiliate of TD Ameritrade. “I do think they are a harbinger of overvaluation. I also think that when people have to start making up new calculations to justify current valuation, that it is a sign of a top.”