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There's No Magic Number

|Includes: Schlumberger Limited (SLB)

In my first year studying economics at the University of London, I took a class on financial accounting.

I’ll never forget my lecturer; he was an older British man who had been an accountant for around 40 years and did a little bit of lecturing in his spare time. Professors like that were always my favorites because they were the ones who could really give you color on how the world worked in practice rather than how academics feel it should work. He was always quick with an anecdote from personal experience to illustrate every point he made.

In addition, while British and American terminology for accounting is almost identical, there are some subtle differences such as the fact that the Brits tend to use the term “gearing” rather than “leverage” and the term “profit” rather than “earnings.” Of course, international and US accounting standards also differ in some important ways.

After he discovered I hailed from “the Colonies” he made a point of addressing me directly during lecture to let me know of these subtle differences. The downside of that was that I could never really get away with sitting in the back of the lecture hall reading the FT. I reserved that practice for my course on European Union business law, where my Italian friend kindly provided me with her outstanding and impeccably neat lecture notes.

As you might imagine, in my financial accounting class we studied financial statements and learned how to calculate and interpret several dozen financial ratios. One of the first ratios every investor learns to calculate and interpret is the price-to-earnings (P/E) ratio, the ratio of a stock’s price to its earnings per share. I’ll never fully understand why, but the P/E ratio seems to have some sort of intoxicating allure for investors and economics students alike.

Perhaps it’s the ratio’s ubiquity; the P/E ratio is listed in most stock tables and is among the first bits of information you’ll encounter when looking up a stock on a popular financial website such as Yahoo! Finance or Google. Investing is part art, part science, but many people find numbers to be a crutch they can depend on. The P/E ratio represents a common and well-understood yardstick an investor can digest and quickly interpret.

But one of the most important lessons I learned from my accounting instructor years ago was that the investment valuation process involves a lot more than calculating a bunch of ratios and putting them into some sort of a grand formula to understand a stock’s true value. The P/E ratio is popular, common and easily understood; unfortunately, many investors either over-rely on P/E ratios in their decision-making process or entirely misinterpret the ratio. The P/E ratio is a tool--one of many in the analyst’s toolbox--but it is not a perfect measure.

One common fallacy is that a low P/E ratio is good and a high P/E ratio is bad. I’ve been asked on countless occasions why I recommend a stock with a “high” P/E. There are a couple of problems with this question that make it impossible to answer. First, we must understand what we’re actually talking about when we quote a particular P/E; chances are we’re not even looking at the same number.

Some investors look up a stock on the web and see the trailing P/E, a ratio based on the prior 12 months’ worth of earnings history for a stock. The trailing P/E can be useful, but it’s limited because it’s based on historical data; for example, many stocks had sky-high trailing P/Es in mid-2009 because corporate earnings were, by and large, depressed in the four quarters from mid-2008 through mid-2009.  But valuing a stock based on the worst four-quarter stretch for corporate profits in decades doesn’t make much sense.

Meanwhile, other investors might be looking at the forward P/E. This ratio is calculated based on analysts’ consensus estimates for a company’s future performance. This ratio can make more sense than the trailing P/E because it’s based on the future, not the past. But it’s also limited by the simple fact that forward P/Es are based on estimates and forecasts, which can be dramatically incorrect.

Furthermore, analysts have a sort of herd instinct; when one analyst hikes their estimates, you’ll tend to see others also hike their estimates as well. This often leads to a situation where all of the analysts find an overly bullish consensus near the top of the cycle and are overly bearish near the lows.

And whatever your definition of “P/E,” a high ratio doesn’t necessarily mean that a stock is overvalued and ready to plunge. Check out the chart below of the P/E ratio for oil services giant Schlumberger (NYSE: SLB) going back to 2000.

Source: Bloomberg

From 2000 through late 2002 and into early 2003, Schlumberger’s stock fell amid a broader market selloff. As the chart above indicates, Schlumberger’s stock also began to fall over this time period from close to 100 times earnings down to as low as 30 times earnings by late 2001.

But look at Schlumberger’s P/E in late 2003 and early 2004: The stock had a trailing P/E at that time close to 45. If we exclude the immediate post-bubble high, this would have been considered a rich valuation for the stock. But if you sold Schlumberger in late 2003 or early 2004, you’d have been sorry because the stock rallied from $25 in late 2003 to over $100 by late 2007.

Similarly, the stock topped out in 2007-08 just as the P/E was touching its decade low. If you think about it, this all makes mathematical sense in that companies in cyclical industries will always have depressed earnings and, therefore, high P/Es near the bottom of the cycle. That’s exactly when you want to buy these stocks; high P/E ratios are actually consistent with buying opportunities and low valuations in cyclical industries.

Of course, this is based on historic P/Es. But consensus expectations for a stock like Schlumberger tend to be fairly depressed near cycle lows as well, inflating consensus estimated P/Es. For example, consider that in July of 2008, Schlumberger’s P/E based on 2009 earnings estimates was actually lower than it was in mid-March 2006.

But in the six months that followed Jul. 15, 2008, the stock fell 58 percent and in the six months after Mar. 15, 2009, the stock soared 53 percent. My point is simple: Understanding whether a stock is cheap or dear requires that the analyst make some sort of evaluation as to where we are in the cycle, in other words, whether fundamentals are improving or still deteriorating. You can’t make that determination by solely looking at P/E or any other ratio.

P/Es can be valuable when evaluated alongside other data but are useless and meaningless in a vacuum. In an upcoming issue I’ll take a look at insider-trading statistics, another indicator I’m often asked about that is egregiously misinterpreted.

Disclosure: "No Positions"