Can You Trust A Company's Price to Earnings (PE) Ratio?

May 24, 2018

Traditional fundamental equity valuation based on the price to earnings (PE) ratio has always been a metric for investors. In theory, assessing the value of a company’s equity based on its core earnings seems logical. In practice, there are reservations about the ability of the price to earnings (PE) ratio to accurately forecast the future price of a stock. According to a study by financial services firm William O’Neil and Company, in which US stock data ranging back to the 1880’s was analyzed, forecasts based on price to earnings (PE) ratios have had limited success in predicting whether a stock’s price would rise or fall.  

There are numerous examples in recent years to justify investor skepticism towards the price to earnings (PE) ratio investment approach. Amazon (AMZN), despite having a F12M P/E ratio of 186x at the start of January 2018 (nearly 9x the Dow Jones Industrial Average price to earnings (PE) of 22.3x), has seen its stock increase by 36.22% YTD. Entertainment provider Netflix (NFLX) has seen an even more dramatic positive move, rising 81.87% YTD. Netflix (NFLX) should have been considered significantly “overvalued” before the stock’s rapid increase with a F12M P/E of 94.48x as of December 29, 2017. Square Inc (SQ) started CY2018 with a PE of 104.12x yet has gained 58.50% this year. These 3 companies, each considered “expensive” when using a true PE metric, have collectively outperformed the S&P 500 by an average of 56.95% (total return) on a YTD basis.

A significant drawback of the price to earnings (PE) ratio is its inability to properly discount future growth potential. A company that appears “overvalued” on a price to earnings (PE) ratio basis, may simply have growth projections priced into the stock; the price to earnings (PE) ratio will contract as the company’s realized earnings catch-up with its forecasts. Some stocks trade at a more expensive price to earnings (PE) ratio due to the quality of their earnings – more predictable and stable earnings. If the drivers of a company’s earnings are considered sustainable or low risk, investors are likely to be willing to pay more because the firm has a higher probability of being profitable over the long-term. 

A company may trade at an elevated price to earnings (PE) ratio that appears to be disconnected with its current profitability during periods of time of high growth and/or large reinvestment.While a company’s price to earnings (PE) ratio should not be ignored, evaluating the merit of an investment based on a company’s price relative to earnings can cause investors to overlook future wealth creation opportunities. Rather than solely focusing on price to earnings (PE) ratios as a determinant of an investment’s worthiness, fundamental investors would be better served analyzing factors such as company’s price to earnings growth (PEG) ratio, earnings trends, operating efficiency (margins), management team, and expenditures. 

Here at Quantamize, we focus not only on these factors but others such as accruals, return on invested capital (ROIC), EVA, and EBIT/EV yields.

Next time when looking at companies such as Amazon (AMZN), Netflix (NFLX), and Square Inc (SQ), it may make sense to look-past their price to earnings (PE) ratio and focus on other value factors.