Everything you want to know about P/E but afraid to ask

P/E is the most misunderstood indicator. However, it could be the most useful one.

* Better definition.

P/E should be inverted as E/P, which is termed as Earning Yield. Earning Yield is easy to compare and understand. It takes care of negative earnings for screening stocks and ranking. If you sort P/E in ascending order, your order is wrong with negative earnings but right with E/P.

It is usually compared to a 10-year Treasury bill yield (or 20 or 30 years) or a CD rate. If the stock has 5% and your one-year CD is 1%, then it beats the CD by 4% in absolute number and many times better percentage wise. However, the CD is virtually risk free and the future earning yield is an educated guess and it may not materialize.

* Many ways to predict E/P.

·         Based on last 12 months. Project it to future E/P. It is also called last twelve month E/P.

·         Based on analysts' educated guesses. Guesses may not materialize. From AAII screens based on data for 10 years for expected PEG and historical PEG (cannot find screens for P/Es), the expected usually predicts better than the previous one that is based on last 12 months. This is the one I use most and many investing subscriptions provide this expected P/E.

·         Based on last month or quarter. Latest information could be better for prediction. However, they are not good for seasonal businesses such as retail where most sales are done in the Christmas season.

* Best E/P could not be the best.

Very high E/P could be sign of troubles ahead like lawsuit pending, fraud, etc. You can find companies E/P over 50% and it means two years' profits could equal to the entire cost of the company! I can tell you right away they smell fishy as there is no free lunch in life.

However, from time to time, some bargains exist due to certain conditions or Wall Street is just wrong about the company. You need to find out whether they are bargains or traps. When the E/P is low (sometimes even negative) but it is improving fast, it could mean big profit for you.

During a recession, a good company should not concentrate on sales as it is the most expensive time to market products in particular on new products, but it usually is the least cost to develop products. In this case, there is no alarm even with negative earning. The only alarm is the high burn rate.

* E/P and PEG.
For value investing, E/P is usually used, the higher the better but not extraordinary high as described above. PEG measures the rate of improving E/P. For growth investing, PEG is usually used. Select one that favors the current market conditions whether it is value or growth.

In a secular bull market, growth is usually better than value. Value (opposite to growth) is better in early recovery stage of the market cycle - the best result is selecting top stocks sorted by Value/Timing in descending order.  Value and Timing could be one composite metric classified by some investment newsletters /  subscriptions.

* Fundamental metrics.
E/P is one of the metrics you should use but not exclusively. If the earning yield is high but the % of debt is too, then a good bargain may not be as good as it appears to be.  See next chapter on other metrics.

Some other metrics may not be easily found in the financial statements like the intangible, insider buying, pension obligation, losing market share, customers’ loyalty, etc.

* P/E variations.
There are other P/E variations like Cape. Personally I like to compare its current P/E to the average P/E for the last 5 years and/or compare it to the average of the companies in the same sector.

P/E is more reliable for a group of stocks like SPY instead of individual stock which has too many other metrics to deal with. 

Shiller P/E  is one way to track the current market valuation. It is controversial and its value is easily misinterpreted. Hence, use it as a reference only unless you understand all its issues.

When you compare the total return of an ETF, you need to add the respective dividends of an index to ensure a fair comparison with total returns. Currently, S&P500 is paying about 2% dividend.

You may want to take out the cash per share from the P to have a better indicator. Some cash-rich companies like MSFT and CSCO could have a better P/E than with the cash.

EV/EBITDA is another way to measure the value of a company. This metric has both advantages and disadvantages over P/E. Click the above links for more information which is beyond the scope of this article.

* Garbage in, garbage out.
I do not trust in most financial statements of emerging countries especially the smaller ones.  Watch out for fraudulent data.

Summary.

Again, one metric should not dictate the reason to trade a stock. Most metrics can be manipulated and give different prediction in different market conditions.

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My e-book Debunk the Myths of Buffett could save you a lot of money in investing.
  http://ebtonypow.blogspot.com/2012/12/special-debunk-myths-of-buffett.html

Sample portfolio for the book.
  http://stockportfolios.blogspot.com/2013/03/welcome.html

(c) 2013 Tony Pow

Disclaimer. I'm not responsible for your actions in your investment. Treat this as educational information and past performance does not guarantee future performance.