Problems With Price-Earnings Ratios

The price-earnings (P/E) ratio is probably the most widespread analytical calculation used by investors.

Yes, it can provide insight into a company’s share price. Note that I say can, not does.

But there are also a few potential problems with P/E ratios.

Garbage In – Garbage Out

Calculations are only as good as the quality of inputs.

If it were easy to estimate future earnings and price-earning multiples, one could accurately chart future share price. Then analysts would be at home getting rich, not crunching numbers all day in a tiny office or cubicle.

There are so many variables that need to be factored into a company’s future earnings that it is impossible to get them all right, or even close to right.

And there are always unforeseen events that take place to complicate things further. Even if your data is pristine and not garbage, you still run the risk of getting it wrong.

On September 10, 2001, I do not imagine many analysts factored in the next day’s terrorist attacks that impacted share prices across the board.

In 2016, how many analysts foresaw the Trump election in the United States? Not that this is directly correlated to the yuugge increase in equities in 2017, but there was some impact. Not to mention all the “experts” who claimed that stocks would tumble if Trump was elected.

In late 2017, tax reform legislation was passed in the United States. Again, this was unforeseen a year prior and will have direct impact on many U.S. based companies. As well, if you follow international news, there is concern in many countries that U.S. based companies may now have competitive advantages over (say) German or Australian firms. This has led to calls of similar corporate tax reform in these jurisdictions to level the playing field.

So many examples out there of how consensus views suddenly had to adjust. In 2018 and beyond, this will also be true.

Both the number of variables and the possibility of unforeseen events occurring makes it very tough to accurately estimate EPS. And the farther away the estimate, the greater the probability of error.

When relying on someone’s estimates, never take them as the absolute truth. Inputs may be good at that moment in time, but may become irrelevant in the near future.

Data is Fluid

The data impacting future earnings is always changing. Similar to my above examples, these occur at the company level.

Each day new information is uncovered that affects a company’s future performance. The departure of a key executive, the announcement of a new contract for sales to China, a lawsuit against the company, a new product, etc.

With each piece of new data, the expected future results will change. As such, both future expected EPS and P/E for a company may be fluid and shift up and down over time.

No One Sees Things the Same

Different analysts may arrive at completely different conclusions, even given the same facts.

For example, consider JPMorgan Chase. A rather large company in the relatively stable finance sector. Not hugely volatile.

Per Yahoo Finance as at January 2, 2018, JPMorgan has 26 analysts estimating its 2018 EPS. The average estimate is USD 7.77. However, the lowest estimate is USD 7.45, while the highest is USD 9.25.

Not a huge variance, but given that all analysts should have access to the same raw data, you would expect a much tighter range. The difference is due to how each analyst interprets each variable.

Even at this level, who is “right” and who is “wrong” can result in different valuations.

As at January 2, JPMorgan traded at USD 107.26 with a 15.46 trailing P/E ratio. If the ratio holds, the consensus opinion is that JPMorgan has a target share price as at December 31, 2018 of USD 120.12. A nice gain of about 12% for 2018.

However, the pessimistic analyst with the USD 7.45 EPS estimate only expects a price of USD 115.18. A gain of only 7.4%. Whereas, the analyst who estimates EPS of USD 9.25 expects a share price of USD 143.00. A gain of 33.3%.

Quite the different outcome for two investment professionals assessing the same raw data.

And that is an established company in a relatively stable industry. If you look at small or new companies, or those in more volatile sectors, you will likely see greater dispersion in estimates.

For example, Facebook (FB). As at January 2, it has 41 analysts predicting 2018 EPS of USD 6.63. At today’s share price of USD 180.21 and trailing P/E ratio of 34.88, that leads to an estimated share price of USD 231.25. For a gain of 28.3%. Much better than the consensus 2018 increase of 12% for JPMorgan.

However, the range in 2018 EPS estimates for FB go from USD 5.73 to 7.45. At the high end, that translates to a share price of  USD 259.86 and a gain of 44%. But on the low side, it may mean only a share price of USD 199.86 and a 10.9% increase. At this lower level, JPMorgan might actually be the better (and less risky) investment.

You can see there is quite a range of results depending on how the raw data is interpreted. Who you follow can play a significant role in your investment choices and expectations.

Bitcoin (and other cryptocurrencies) is an extreme example of this. At the end of 2015, Bitcoin traded at USD 429.78. By the end of 2016, it was trading at USD 958.24. A gain of 123%. Nice.

Starting 2017, some saw Bitcoin much like Dutch tulips. Others as the wave of the future. But I am not sure very many estimated Bitcoin trading near USD 15,000 at Christmas. Quite the increase.

This is why investors religiously follow specific analysts who have excellent track records. And why these same analysts earn extremely high compensation.

And yes, I am ignoring the herd mentality effect of analysts. Something that is very real and actually works to keep estimate ranges closer than they should be. A few analysts like taking contrarian views. But the mast majority like to hide safely within the herd.

Sometimes All Stocks Are Down

Even strong companies may fall in price.

In a bear (down) market, many stocks appear undervalued. But until the market, as a whole, improves and investors start to invest in equities again, the undervalued stocks may not increase in price.

In fact, they may fall even further.

Just because a good company has a low P/E does not mean it will rise in price anytime soon.

One needs to have patience when value investing.

The same is true in bull markets. Some companies just ride the market wave, resulting in over generous P/Es.

Undervalued or Junk?

Investors value a company’s growth potential in the P/E calculation.

If investors believe the potential for a company is strong, it will have a higher P/E than one whose prospects are weak.

If you focus only on stocks with low P/Es, you may find some undervalued companies. But you may also end up investing in firms whose earnings potential is seen as weaker than in comparative companies.

Separating the value plays from the dogs is always a challenge.

The quantitative analysis may give the same results to two companies. But one may be a value stock, the other a piece of junk. That is why investors should never rely on P/E, or any ratios, on their own. They need to be combined with qualitative analysis.

It is the qualitative, not the quantitative, analysis that separates the good from the bad.

I suggest you never forget that.

Next up, the price-to-book ratio.