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Why P/E Isn't All It's Cracked Up To Be

If you had to pick one analytical metric to utilize when making an investment decision, what would it be? Most of us would consider that an unfair question, since we generally gravitate to a plethora of information when putting money to work in the market. However, if forced into a decision, many might pick P/E, the price to earnings ratio, as it is generally considered a golden standard of equity analysis.

How Much Stock Should You Put In P/E?

From a point in time perspective, whether measured on a trailing or forward basis, P/E tells us a lot. It tells us how much we are currently paying for corporate earnings and it tells us, comparatively speaking, how "cheap" or "expensive" one equity is versus another. In a totally apples to apples comparison, a security with a low P/E theoretically would represent a more prudent purchase versus one with higher price to earnings.

The problem is, in the real world, security comparison is never apples to apples, which would seem to render P/E as somewhat flimsy in the due diligence process. And since security price movement tends to be predicated on absolute corporate performance and forward expectations, a point in time analysis method might be considered too simplistic and perhaps unreliable to serve as the keystone of an investment decision.

And P/E only measures operating performance. It does not take into consideration the broader corporate picture of balance sheet assets/liabilities, company intangibles, brand identity, or other statistics that might cause investors to place a premium or slap a discount on a stock.

Taking P/E One Step Further

Quantitatively, we can add a layer of forward predictiveness to P/E by calculating the PEG ratio. PEG, or price to earnings growth, provides for a more meaningful valuation tool when utilized with correct assumptions. Calculated by dividing point in time TTM P/E by projected earnings growth, PEG affords the ability to judge, side-by-side, securities with differing baseline P/Es and varying anticipated growth rates.

As an example of how PEG works, lets take Stock 'A' which has a current TTM P/E of 16 and is expected to grow earnings by 7.5% next year. We'll compare it to Stock 'B' which has a TTM P/E of 24, but is expected to grow earnings by 11.25% next year. If we divide the P/E by the growth rate in both situations, we end up with identical PEG ratios of 2.13, signifying a similar overall operational value proposition, despite the varied P/E and growth rates.

Why A Low P/E Won't Necessarily Protect You

Value investing is typically associated with below market P/E ratios, although I think that is a very fallacious and limiting generalization to make. I would argue there's much more value in a stock selling at 20+ earnings multiple growing dependably in the low teens year-in, year-out like a Costco (NASDAQ:COST) than there is in a company selling at a mid-teens multiple like a Procter and Gamble (NYSE:PG) with an erratic and "undependable" recent earnings history and outlook.

One might argue that a stock selling at a higher P/E, like Costco, presents more capital risk simply because the multiple has more room to compress should times turn bad. While that may be true, on the flip side, a lower P/E stock like Procter won't necessarily provide value or capital protection if the growth rate remains too low or stagnant to justify the lower multiple.

On a further note, let's take former tech high-flier Apple (NASDAQ:AAPL). Despite the explosive growth from '09 to the middle of last year, when earnings grew roughly four-fold, Apple's P/E hovered mostly around 20 when measured on a TTM basis. Trading at $700 during the peak of its frenzy last year, many pundits called Apple "cheap," anticipating continued parabolic earnings growth and deserved earnings multiple expansion. As we know now, there has been a turnover in the Apple growth story, and those who bet big on Apple last year have fallen victim to a value trap.

AAPL 5-Year

The reservation by investors to reward Apple with a premium multiple, despite its parabolic growth, in hindsight was well taken. Given the tech bubble we experienced around the turn of the century, one might have expected a more lofty multiple for a company growing earnings 50-75% a year. And with earnings growing faster than the applied earnings multiple, a PEG of less than 1 was in force, and depending on where you see earnings headed this year, still is.

At one point during the Internet bubble, Cisco (NASDAQ:CSCO) traded in excess of 100 times earnings. To put some perspective on the matter, had Apple been given that type of multiple, it would have traded in excess of $4500 based on its FY'12 $44.64 in earnings.

So why didn't the market apply much of a premium to Apple, despite its historical build out? Perhaps lessons learned from a decade ago? Maybe the sheer size of the company? Possibly awareness that iPad and iPhone sales and margin metrics would slow and no new disruptive product would make its way to market? Whatever the case, with Apple down 35% from its highs last year, pundits continue to point to Apple's P/E and scream value. I'll let you decide if that's a worthy argument or not. I'm long Apple myself, but I'm not personally pounding the table on the stock, low P/E or not.

The opaque financial outlook at Apple continues to be troubling. No one was quite clear how fast earnings and margins were growing in the past, and now there is little clarity to what extent earnings and margins will moderate in the future. In other words, the waxing and waning of earnings growth has been extremely unpredictable and undependable, leaving for a perplexed investment community and volatile stock.

The Final Calculation

Many of us spend a lot of time analyzing financial data and comparing valuation models of dozens of different companies. While I'm not inclined to say it's a waste of time, I do think valuation means little in the absence of dependability. Without confidence in what a company will achieve going forward, we are nothing as investors and become little more than speculators. A high P/E company with clear vision and transparent management may possess much more investment value to us than a company with a low P/E, a blurry outlook, and/or potholed past.

On the other hand, companies with seemingly clear visions can quickly lose their ways and/or be flanked by enterprises that were once priced for the dead. I'd argue that the biggest value you can bring to your portfolio is in spending a disproportionate amount of time deciphering whether a company can build value from this point forward. Scrutiny of corporate financials, historical performance, and evaluation of an alphabet soup of metrics may provide for a nice baseline analysis and valuation dissertation, but that analysis is basically meaningless without a robust forward growth thesis.