Can Investors Still Rely on a Stock’s P/E Ratio?

May 11, 2008

Vitaliy N. Katsenelson, CFA submits:

I
love the price/earnings ratio, but like all investment tools, it is
flawed. This is because it is only as good as the numbers that go into
it.

There
is no debate about the “p” in the equation – price is quoted every
second. But the “e,” though readily available, is only as good as the
best estimates. Many
people describe the stock market as cheap. After all, at 18 times
earnings, p/e’s are half of what they were eight years ago (those bubbly
valuations are not coming back anytime soon) and only three points
above their long-term average of 15. However, the “e” is temporarily
inflated by all-time high (pre-tax) profit margins, which are at 11.5
per cent, or about 35 per cent higher than their multi-decade average
of 8.5 per cent.

Complete Story »