The Decline of the P/E Ratio

yahoo wsj ^ | Monday, August 30, 2010 | Ben Levisohn

[BenLurkin]

The P/E ratio, thrust into prominence during the 1930s by value investors Benjamin Graham and David Dodd, measures the amount of money investors are paying for a company's earnings. Typically, companies that post strong earnings growth enjoy richer stock prices and fatter P/E ratios than those that don't.

But while U.S. companies announced record profits during the second quarter, and beat forecasts by a comfortable 10% margin, on average, the stock market has dropped 5% this month.

The stock market's average price/earnings ratio, meanwhile, is in free fall, having plunged about 36% during the past year, the largest 12-month decline since 2003. It now stands at about 14.9, compared with 23.1 last September, based on trailing 12-month earnings results. Based on profit expectations over the next 12 months, the P/E ratio has fallen to 12.2 from about 14.5 in May.

So what explains the contraction? In short, economic uncertainty. A steady procession of bad news, from the European financial crisis to fears of deflation in the U.S., has prompted analysts to cut profit forecasts for 2011.

"The market is worrying not just about a slowdown, but worse," said Tobias Levkovich, chief U.S. equity strategist at Citigroup Global Markets in New York. "People want clarity before they make a decision with their money."

Three months ago, analysts expected the companies in the Standard & Poor's 500-stock index to boost profits 18% in 2011. Now, they predict 15%. Mutual-fund, hedge-fund and other money managers put the increase at closer to 9%, according to a recent Citigroup survey, while Mr. Levkovich's estimate is for 7% growth.

"The sustainability of earnings is in doubt," said Howard Silverblatt, an index analyst at S&P in New York. "Estimates are still optimistic."

[ClearCase_guy]

Summer of Recovery
Fall of Prosperity
Winter of our discontent

[1rudeboy]

Interesting read. I stopped paying attention to p/e right before the tech bubble burst, but still cast an eye on it now and then.

[proxy_user]

Earnings can be BS, especially nowadays when they take a special charge or gain every quarter. The thing to look at is free cash flow from operations.

[CdMGuy]

Like everything else, the PE ratio was in a bubble. It was ridiculously high. Now that it is back in a more normal range, where it has reverted to the historical mean, we should be happy that reality is returning to the stock market.

[catnipman]

“Like everything else, the PE ratio was in a bubble. It was ridiculously high. Now that it is back in a more normal range, where it has reverted to the historical mean, we should be happy that reality is returning to the stock market.”

Very true. Also, whenever the PE ratio is at odds with other supposed valuation metrics, the pundits come out and declare it dead. But it always turns out that the other valuation metrics eventually prove to be BS, and quickly get discarded.

Of course, all rules are out the door when Marxists are in charge of the economy.

[expat_panama]

It's easy to complain about the PE but it's a poor carpenter that blames his tools.

PE's are fine but in this wonderful info-age there're so many other fine tools; like, why divide last years earnings by today's price if you want a good guess about tomorrow?   This is where some people prefer the 'forward PE' that divides expected earnings by today's price and gets right into problems with the question of just what kind of earnings do we really think we can expect.

Me I stick to earnings growth over the past 5 years.

[Ramius]

The P/E is my number one measure when I’m evaluating a stock. It’s the one that matters most. Sure, there are some conditions that will throw off a P/E either up or down from time to time— but that’s all part of evaluating a company and making the investment decision. One of the biggest “buy” signals I can imagine is when I can show why I think the P/E is greatly overstated. But in the end... P/E matters.

For too long— and a big part of the tech bubble— was that people started thinking that P/E’s of 40, 50... 100 or gawdhelpthem 300 were reasonable. Sorry, but earnings matter. Real, honest, end-of-the-month earnings.

I wouldn’t consider anything with a P/E over 20, and I prefer stocks with a P/E under 10. Unlesss... as I said... I can explain why the P/E is overstated. For a P/E under 5... there’s something else going wrong there. Makes me suspicious.