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Thursday, March 22, 2012

Why the price-to-earnings ratio is not an adequate valuation metric

The price to earnings ratio is often used as a measure of corporate performance and overall market performance via the P/E ratios of whole indexes. If the ratio is low in comparison to previous levels then the market is sometimes believed to have room to rise even if it is already inflated. For example, market analysts and observers such as StockCharts.com illustrate this point. Moreover, since 82 percent of companies that reported Q4, 2011 earnings had GAAP vs Operating P/E ratios that were in-between 15 month highs and lows, then those companies are believed to be fairly valued per Stock Charts. The P/E ratio is further illustrated below:

Even GAAP or Generally Accepted Accounting Principle Price to Earnings ratios can be misleading however. This is because it measures earnings and not revenue. Earnings are what are left after a company deducts outflows such as expenses, and dividends. So if revenues decline quarter after quarter, but earnings rise relative to price via cost cutting, then it will appear as though the company is becoming cheaper. For example, ABC Corporation earns $100 million on 5,000,000 shares in Q3, 2011 and has a share price of $300 giving it a P/E ratio of 15. Then in Q4, 2011 ABC Corporation increases earnings to $125 million by laying off 625 workers at 40k/yr; the price rises to $325/share and the P/E ratio drops to 13 making it seem undervalued.

Clearly the above corporation is questionable investment if it has to lay more people off to stay profitable. The price to earnings ratio does not measure underlying financial conditions.  But that's not all, if cost cutting has already been tried, and that option is no longer available because it would actually cause earnings to decline, ABC Corporation can also reduce the P/E ratio by purchasing existing shares or issuing new shares if the price per share declines. To illustrate,  if ABC corporation purchases 1,000,000 shares in Q1, 2012 and both earnings and share price remain near their $125 million and $325 levels, the P/E ratio then drops even more to 10.4. All the company did was shrink its own shares outstanding.