One of the most common questions that I get from investors is what criteria I use for stock picking. Often, they will ask me about one of the simplest measures: the price-to-earnings ratio, or “P/E ratio”. The P/E ratio is determined by dividing the current price of the stock by the earnings per share of the company in question. Accordingly, it is very simple to compute.
Most academic discussion that surrounds the use of the P/E ratio to pick stocks relates to whether investing in low P/E ratio stocks, which are often referred to as value stocks, results in higher than average returns. While controversy remains regarding this issue, the evolving consensus seems to be that while low P/E stocks do outperform high P/E stocks, this difference is explained by risk, or more specifically, a higher required rate of return.
There are many problems with using the P/E ratio as an exclusive tool for investing, but I would like to focus on one that is often overlooked: the denominator “E” (earnings per share) value that is used. Many research analysts and newsletter writers fail to differentiate between trailing and forward P/E ratios and do not disclose which they use. The earnings per share figure in a trailing P/E ratio is typically the sum of the four most recent quarters of earnings per share. In contrast, the earnings per share figure used in a forward P/E ratio is a forecast of what earnings will be in the next fiscal year. This distinction is particularly important in the current market environment where earnings for many companies in the past year have been cyclically low due to recessionary conditions.
So when current stock newsletter writers are saying that the current average P/E ratio of the S&P 500 is far too high given historical levels and this implies that the market will drop again, one has to question the data they are using. Trailing P/E ratios seem to be inappropriate because, for most companies, earnings are expected to be higher in the next year. Given that the stock market is typically forward-looking, one would expect high trailing P/E ratios when the economy is exiting a recession. Given the uncertainty in the present day stock market and higher than normal volatility, I also believe that forward P/E ratios are not very helpful either. As I mentioned earlier, forward P/E ratios are based on estimated earnings for next year. However, those who provide forward P/E ratios usually do not describe the basis for these future earnings estimates. They are based on many assumptions, some of which may be incorrect.
I believe that there are much better ways of determining whether certain stocks are undervalued. In future posts, I will describe many of these and also point out potential pitfalls in each investment tool. The good news is that I believe that methods for choosing superior equities exist, and surprisingly, many of the best tools are qualitative rather than quantitative. The bad news is that using these methods to pick a portfolio that will outperform the market is extremely time consuming, and depending on the size of your portfolio, the value of the time you spend on research may offset the extra return you will generate. Still, I believe that some of the simpler tools that I use do have a good track record for beating the market.
