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Don't Buy the P/E Ratio Hokum

By Michael Carr   |   Thursday, 26 Feb 2009 11:35 AM

Many investors think they understand the meaning of price-to-earnings ratio. And you’ll hear a lot of financial voices talking about P/E ratios these days, in hopes of convincing you that stocks are cheap, or that they are still too expensive.

Let’s put all this into perspective.

Simply put, dividing a stock price by the earnings per share provides a number — the P/E ratio — which can be used to compare different stocks. The same concept can be applied to a stock index, like the Dow or the S&P 500, to assess whether or not the market as a whole is overvalued or undervalued.

On a historic basis, for instance, major stock market indexes have traded with an average P/E ratio of 15, according to data provided by Wharton Finance professor Jeremy Siegel in his book, “Stocks for the Long Run.”

Right now, by some accounts, the S&P 500 is trading with a P/E ratio of about 14. This value uses the earnings from operations that companies have reported over the past year.

At this level, stocks would be slightly undervalued and would thus represent a good buy for long-term investors. So far, so good.

Pessimists, however, often look at the “as-reported earnings,” which include many estimates of expenses and mark-to-market valuations of illiquid investments. This value of “E” gives us a P/E ratio of right now of 30 — far higher than Siegel’s long-term ratio of 15.

Others use forecasted earnings per share because the market looks forward and should theoretically be priced into the future.

Unfortunately, no one knows the future.

For example, Merrill Lynch now estimates S&P 500 earnings will total $28 a share in 2009, while Standard & Poor’s estimates range from $32 to $66 per share depending on which method they use. These are big gaps.

Fundamentally, the problem is earnings. Most investors would assume “earnings” means simply the amount of money a company makes by selling its products or services.

Yet, earnings is an accounting concept and can be highly flexible — and thus can be manipulated by a company. That’s the risk of using a P/E ratio. The calculation is clear enough, but the inputs might be completely wrong

Instead of letting accountants and company management define earnings, I recommend the method employed by billionaire investor Warren Buffett.

When evaluating a company, Buffett looks at “owner earnings,” which he defines as reported earnings plus depreciation, depletion, amortization, and certain other non-cash charges, and then minus the average annual amount that the business requires to fully maintain its long-term competitive position and its unit volume.

The owner-earnings equation does not yield the deceptively precise figures provided by most accounting statements since the last item — the money the business needs to stay competitive — has to be a guess, one sometimes that is very difficult to make.

This is where Buffett’s genius steps in. And by genius, of course, I mean hard work.

For instance, “depreciation, depletion, and amortization” are accountants’ estimates of the fixed cost of doing business. Machines wear out and companies need to replace them. By using judgment instead of rigid depreciation schedules, Buffett is thinking like an owner rather than as a stock analyst.

The P/E ratio as calculated above comes closest to Buffett’s working definition. For instance, I use operating earnings, which excludes the noncash charges, and I assume that companies are able to roughly estimate required future business investments.

The other key to his style, of course, is buying a stock low and holding it virtually forever.

In the end, we can minimize guesswork and make decisions from the same facts that Buffett relies on — actual earnings generated by the business — without factoring in all the accounting gimmicks.

By that measure, things aren’t so bad and some stocks are worth looking at for long-term investors.

Consider big drug stocks right now. They have low P/E ratios, calculated with any measure of earnings, which indicates that some of the large cap drug stocks will offer growth once the market recovers.

And, their bond-like dividend yields offer downside protection while rewarding patient investors.

With little downside left in these stocks, they represent a good buy in uncertain times and many of these companies have reported past earnings which easily allow them to pay relatively high dividends.

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Many investors think they understand the meaning of price-to-earnings ratio. And you’ll hear a lot of financial voices talking about P/E ratios these days, in hopes of convincing you that stocks are cheap, or that they are still too expensive.Let’s put all this into...
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