The Perils of the Price to Earnings Ratio
March 23, 2007
The price to earnings ratio is one of the most common methods used to value common stocks or the market, not only by professional investors but individuals as well. An investor will look at a graphical depiction of a time series of the price to earnings ratio of either the market or an individual stock and then decide whether the company or market being analyzed is “cheap” or “expensive” relative to its history. However, this method can give a false signal when used to analyze stocks that are in industries where earnings have a pronounced cyclicality. That is to say that with “deep cyclicals” when a stock has a high price to earnings ratio it is actually cheap, and when it has a low price to earnings ratio, it is actually expensive. This is because the denominator of the ratio (the earnings) is extremely volatile and can become quite small relative to the price of the company’s stock when earnings are troughing. How does this work exactly? As you can see in the table below, the earnings are deeply cyclical moving from $0.20 to a peak of $4.00 in 2000 before dropping down to $0.20 in the trough in 2002. Although the stock price declines as well, it does not fall as much as the earnings. This causes the PE ratio to be extremely high when it is time to buy and low when it is time to sell.
|
1997 |
1998 |
1999 |
2000 |
2001 |
2002 |
Price |
$ 10.00 |
$ 20.00 |
$ 25.00 |
$ 30.00 |
$ 20.00 |
$ 10.00 |
EPS |
$ 0.20 |
$ 0.75 |
$ 1.60 |
$ 4.00 |
$ 0.70 |
$ 0.20 |
PE Ratio |
50.0 |
26.7 |
15.6 |
7.5 |
28.6 |
50.0 |
The first chart presents the argument graphically. Although this example is fictional, many examples of this can be provided in the stock market. The second example is a three-year chart of Transocean (RIG) shows the stock selling at $54 a share, a 52 week high, yet the Price to Earnings ratio is at 22, which is the lowest since early 2003. In late 2003, when the stock was selling at around $18 per share, the Price to Earnings ratio was at 33 times. In both situations a false signal of ‘expensive” and “cheap” was generated. This does not mean that the price to earnings ratio is an invalid measure of the “value” of a stock, but that it should accorded a more detailed examination before being used.
