Does the P/E Ratio Really Tell You Which Stock To Buy?

The Price to Earnings Ratio for the vast majority of shares in which you might be considering investing is readily available, and for those you cannot find, the vaunted P/E is easy to calculate on your own.  All you have to do is get your hands on a copy of the company’s latest annual report.

The P/E in many ways says something to every investing strategy.  Investors seeking gargantuan returns in the future gravitate towards high P/E shares; the slow and steady value investor is repelled by the same P/E, finding it too expensive.  If you stop and think about it for a moment, does the P/E really tell you what to do to achieve the goal for which you started investing – making money in the future?

No investor cares about how much was made on shares in the past.  Investors care about the future.  Yet the P/E you find quoted everywhere is most often what is called a Trailing P/E.  For a quick review, here is the formula used for the P/E Ratio:

P/E Ratio = Share Price/Earnings per Share

The earnings per share used in the denominator are for the prior year, hence the term “trailing.”  Ardent proponents of the P/E Ratio cite this as a distinct advantage of the Trailing P/E, since it represents hard numbers that were actually achieved and are etched in stone now and forevermore.

Skeptics ask what predictive value prior earnings have?  Enter the Forward P/E Ratio, which you calculate as follows:

Forward P/E Ratio = Share Price/Projected Future Earnings

Here the denominator is not past earnings, but projected future earnings.  Projections are estimates, or some might say “guestimates,” of performance that might or might not take place in the future.  The estimated earnings per share figure is a consensus estimate, derived from the estimates of all the professional analysts covering the stock.

As such, many feel the Forward P/E to be of little value, since analyst opinion is quite often flat out wrong.  Few analysts accurately predicted the market crashes of recent years and some who did have been making the same predictions for decades.  Sooner or later, even the voice crying in the wilderness that the sun will not rise in the morning will be proven right.

But what of the “actual” earnings per share reported in a trailing P/E?  How accurate are they?  The numbers come directly from a company’s financial statements, after being certified by an accountant.  There are accounting and legal standards to be met, so one would assume the numbers to be valid, but one could be wrong.

Some retail investors assume the purpose of a company disclosing its financial performance is to inform the investing community on the current state of the company.  History has proven that a dangerous assumption to make.

Better books on how to read financial statements will all tell you the same thing.  The purpose of the statements is to put forth the company’s position in the best possible light, even to the point of misleading and in extreme cases, outright fraud.

If you doubt that, read the book “The Smartest Guys in the Room,” which is the story of the Enron collapse in the United States.  Pay particular attention to the prominent role played by Enron’s prestigious accounting firm, Arthur Andersen.

Indeed, financial analysts say you learn more about what is really going on with a company from the Auditors notes section attached to the annual reports and quarterly statements.  If you want to learn more about how to analyse financial statements, look for books written by the best analysts out there – credit analysts.  They go deeper to read between the lines than many share market analysts do, since they have the responsibility of advising on loan decisions.

All the information used to calculate the many financial ratios on which we rely to evaluate shares comes from the financial statements.  The point here is not to mistrust what you read, but to dig into an annual report on your own, rather than relying exclusively on the ratios you find on financial websites.

Some retail investors never take the time to read annual reports of shares in which they are invested or targeting for investment on their own.  They read just enough to understand the basics of financial ratio analysis and rely on others to do their work for them.

In closing, we are going to look at two valuation ratios for two of Australia’s biggest banks, Australia and New Zealand Banking Group (ANZ) and National Australia Bank (NAB).

You have learned that coupling an analysis of a share’s P/E Ratio with its PEG Ratio adds needed information regarding the under pricing or overpricing of the stock.  Here are those two ratios for ANZ and NAB as of the latest reporting:

For a retail investor looking to get into the banking sector, the P/E Ratios taken alone really do not tell you much, other than they are under the historical market average P/E of around 15, and neither is attractive from a growth point of view.

However, an investor who read that a PEG under 1 could make a potential share investment attractive might be enticed by NAB’s PEG Ratio of 0.96.  Coupled with the low P/E might indicate this share is a relatively good bargain.

That same investor found some “rules of thumb” regarding how to use the PEG ratio.  You will find some on the Net who advise investors that a PEG under 0.5 is a strong buy and a range of 0.75 to 1.00 suggests holding the stock.  PEGs between 1.00 and 1.25 are shares you should consider selling while anything between 1.25 and 1.75 is a candidate for shorting.  (In simple terms, shorting a share is in effect a bet the shares will go down.  The investor “shorts” the stock at a certain price, borrowing the shares from a brokerage.  When the shares fall the investor buys the shares, returns them to the brokerage house, and keeps the difference between the shorted price and the purchase price as profit.)

Looking at the ratios could induce a misguided investor to short ANZ, which might have been a costly decision.  In late June 2010, ANZ was trading around $22 per share and as of mid February ANZ was trading at around $26.  Interestingly enough, NAB showed the exact same prince range – trading around $22 in June 2010 and $26 in February 2011.

Perhaps this investor’s research on how to use valuation ratios such as the P/E and the PEG stopped short of the admonition that the PEG Ratio is not very predictive of very large cap dividend-paying value stocks, like NAB and ANZ!