Benjamin Graham wrote in his book "The Intelligent Investor" that in the short run the market is a voting machine, but in the long run it is a weighing machine. This is in reference to how P/E ratios alone do not tell the entire story, even when they're compared within their industry peers. On what basis do analysts claim that a stock is cheap just because it has a P/E ratio in the range of 10-20? Historical earnings and ratios? And how sure are they that the historical earnings will be achieved and sustained once again? We are in a recession, investors are not willing to pay a higher premium anymore per $1.00 of earnings.
Rackspace Hosting Inc. (NYSE:RAX) is a perfect example. Last year company was trading at a 120 P/E multiple, now it is trading with a P/E of 84.19. Maybe investors are realizing that paying $120 per one dollar of earnings is just absurd. I understand that P/E also takes into account company's growth prospects, but a 120 P/E ratio is just not warranted. Other tech companies such as Concur Technologies Inc. (NASDAQ:CNQR), Allot Communications Ltd. (NASDAQ:ALLT) and Parametric Technology Corp. (PMTC) also boast P/E ratios in the triple digits. Seldom companies' revenues and earnings cannot keep pace with astronomical forward P/E ratios. Such was the case with Microsoft (NASDAQ:MSFT) years ago.
Let us reminisce for a minute as to what happened to Yahoo Inc. (NASDAQ:YHOO) before the dot.com bubble burst. On December 7, 1999 Yahoo was screaming upwards, gaining additional 63.6% on top of the 80% gain since that year began. At the time Yahoo's P/E ratio was 263 times revenues and 3,263 times earnings.
What happened next? S&P 500 decided to add the company to its index because of this phenomenal news.
What happened thereafter? S&P's addition brought even more amateur investors to the table, and irrational exuberance was in full effect. Meanwhile in the same month, Yum Brands (NYSE:YUM) was earning more than 17 times Yahoo's size, but yet company's stock was only selling at nine times its earnings and a little over 70% of its revenues.
During security analysis, there is more value placed on P/E ratios than is warranted. The denominator, earnings, is based on an accounting measure which can be manipulated, resulting in a large standard deviation from its average historical P/E measures. In addition, protracted neglect or unpopularity of a security can also cause price declines to unduly low levels. P/E ratios can be very useful at times, but most of the time they are meaningless.