Wednesday, February 6, 2008

Beware the Price-Earnings Ratio

The price-earnings ratio is a tool for measuring the value of stocks. Take the price of the stock and divide it by the earnings per share. Different industries traditionally have had different p/e ratios. Banks and other financial stocks generally have low p/e ratios. Tech companies tend to have high p/e ratios.

Currently, the p/e ratio for the S&P 500 is around 15. That's low compared to the last ten years. Back in the halcyon days of the dotcom boom, the p/e ratio for the S&P 500 got up to 25 or 30. So is the stock market a good buy now?

The utility of the p/e ratio depends on, among other things, the reliability of the numbers. Price is easy enough to determine. Just look at where stocks are trading. Earnings, however, are a different matter. Earnings are calculations of the companies, and they can get them wrong. Think back to the accounting scandals of the early 2000s: Enron, WorldCom, Adelphia, HealthSouth, and so on. A lot of companies did a lot of restating of their financials. A restatement involves a company's admission that the first time it reported its financial results, it got them wrong. People who traded on the first round of results either paid, or received, the wrong price.

The subprime mess is getting uglier, not prettier, and government investigations are underway. Given the losses that have already emerged, the potential for restatements is nontrivial. Today's p/e ratio could turn out to be an illusion.

Another reason to be careful is that huge losses from the mortgage mess, lbo slowdown, and other secondary and tertiary effects of the foregoing, still seem to lurk in the shadows. A messy situation with bond insurers is lurching around. Banks continue to be stuck with lbo financings. Some ordinary business corporations are recording losses because their cash management investments, of all things, are taking hits from the mortgage mess. No one knows how bad things will get. That's why the Fed keeps dropping interest rates at the slightest whimper from the Street. The Fed is driving through a fog in the middle of a moonless night, without a good idea of the scope of the problem.

These losses not only directly impact corporate earnings. They also create a drag on the economy, and have slowed consumer spending. This will cause more deterioration in corporate earnings. Today's p/e ratio may not hold up, in the near term.

A p/e ratio of 15 isn't bad by historical standards, and if you're investing for the long term (i.e., 10, 20, or 30 years), buying now isn't crazy. That's especially so if you have a regular and disciplined savings program. Don't stop saving simply because the market may be headed south for a while. But be cautious about thinking a p/e ratio of 15 is a bargain. A rising stock market covers up a multitude of sins. A falling stock market will reveal them as the tide pulls back.

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