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. (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. (CNQR), Allot Communications Ltd. (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 (MSFT) years ago.
Let us reminisce for a minute as to what happened to Yahoo Inc. (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 (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.