Whenever the stock markets have consolidated and broken down significantly, thousands of bargain hunters are on their way to try and find the one dirt cheap stock in the hope of cashing in large profits once it goes up again!
But when exactly is a stock cheap? For many investors a stock is only cheap when the price-earnings ratio (P/E ratio) is low. So the lower the price-earnings ratio the better it is for them on speculations that it will go to where it was before the stock dropped, if it goes up again.
To recap. A price-earnings ratio shows the multiple of earnings at which a stock sells. Determined by dividing current stock price by current earnings per share (adjusted for stock splits). A higher multiple means investors have higher expectations for future growth, and have bid up the stock’s price.
The thing about P/E ratios is that conservative investors should avoid stocks with a high P/E ratio because if these corporations disappoint with their earnings and don’t meet market expectations, the stock will drop dramatically like Whole Foods did dropping more than $20 at the beginning of November 2006.
If a stock has a low P/E ratio, where expectations aren’t that high, the reaction is far less dramatic if earnings and performance expectations aren’t met.
But if trading and investing in the stock market was that easy, everybody would just buy stocks with a low P/E ratio. To bad so sad that no one would have then had Starbucks in their portfolio. A stock that shot up sky high in the past. A low P/E ratio doesn’t exist in Starbucks vocabulary!
If you disregard individual stocks that have dropped sharply and take a look at the broad market, you’ll surprisingly notice that a P/E ratio tells you absolutely nothing about whether a stock is going to go up or down in the future! Not only stocks with a high P/E ratio can drop, but also stocks with a lower one can.
A good example of the above is the following:
Within the last 4 years the Dutch financial company ING, having a low P/E ratio, climbed to the skies from $10 to over $40. That’s over 300% profits, whereas AIG (American International Group), also having a low P/E ratio, was virtually dead in comparison.
On the other hand, Starbucks and the German cosmetic company Beiersdorf kept on going up although both companies had a high P/E ratio whereas Whole Foods, also having a high P/E ratio, dropped from $80 all the way down to $40 in 2006, and EMC² is still hovering around $15 and hasn’t recovered yet since 2000 where the stock was trading at just over $100.
So as you can see, there are no rules whether a stock with a high or low P/E ratio is good or bad!
Why doesn’t this strategy work?
The problems already start at the very beginning. Which earnings should one take into account? The reported earnings from the previous year; the expected ones for the current year or even the forecaster earnings for the next year?
Because the stock market mainly looks at future performance and earnings, the future P/E ratio plays a more important role. But even the expected earnings of the current year can only be estimated let alone the one for next year. It all boils down to estimation and speculation which is quite common in the stock market. But if these estimates are wrong and market expectations aren’t met, investors are then commonly very disappointed and the stock or even the whole market goes down. And this happens every year somewhere along the line.
And this is not the only reason why a P/E ratio is not a good formula for success. The future performance of a corporation depends on so many factors. A future stock price doesn’t only depend on earnings from the current year or the next. It also depends largely on how well the management does it’s job, whether the company has a strong product line or which possible problems the company may face.
An example of this is Apple (AAPL). When CEO Steve Jobs introduced the iPhone in Jan. 07, AAPL shot up by over $10 in two days. But then Cisco Systems (CSCO) claimed that they had the rights to the name iPhone and were contemplating to sue AAPL if they were to continue using the name iPhone. Well. Guess what happened? AAPL went down the following days losing it’s entire $10 gain.
So once again you can see that a P/E ratio, whether high or low, says way too little to base an investment decision on!
At the end of the day, P/E ratios or any other ratios are absolutely irrelevant. What matters most importantly in the long run are earnings and the overall performance and future outlook of a company! Short-term factors like oil prices, political turmoil etc. can influence the markets and they will more often than not! But in the end these factors are secondary and negligible for long-term investments.