Why PE Ratio Analysis Won't Work

PE ratio analysis (a staple valuation model) has recently been a terrible indicator of a businesses value in the current economic environment. The reason for this is that many of the underlying assumptions for this tool in valuing a company's stock have fallen apart. This includes PE ratio's cousin, PEG (Price Earning Growth), in which case the PE ratio is discounted by the expected growth rate of the company (PEG's usually hover around 1, PEG's over 1 are generally over valued relative to their growth and visa versa).

Current company PE's are generally between 2 and 9, when they are usually around 8 to 16. Based on a previous post, another way of looking at PE is a payback or breakeven period. Assume that you buy a house for $150k and the return is $12k (8% return - Not taking into account discounted cash flows, expenses or taxes). The house will pay for itself after 12.5 years (note the inverse relationship between PE and yield). Also note that this investment scenario would have a PE of 12.5 ($150k / $12k).

Imagine that same house with a PE of 2. Either the same $150k house is now priced at $24k or your earnings have jumped to $75k.

In contrast, that house with a PE of 40 means either the house has jumped in value to $480k or you are now renting the house for $3.75k per year!

The problem becomes obvious. In an economic climate where business are contracting, using any type of PE analysis fails because EPS is declining. The only way a PEG ratio would work is if you can accurately predict the decline in EPS (as well as the corresponding market reaction). Needless to say, with all the conflicting opinions in the market, this is incredibly hard to do (even in a stable growing economy let alone a decline with no definite short term end in sight). Using any trailing EPS is like following lemmings off a cliff and using a Forward PE is risky at best.

Companies with low PE ratios have them for a reason. The trick is understanding if the reason is because the company is on its way out, or if the market has over reacted and unnecessarily punished the stock (Think RIM on Sept 22nd).

When faced with scenarios where PE ratios fail, analysts are often advised to use another method, such as price to book or price to cash. However, the unprecedented decline makes cash a precious and rare commodity and book values can drop just as quickly as earnings under poor management.

In other words, unlike the recent hay-day of financial investing, analysts and advisers are going to have to work harder for smaller returns: seeking to find diamonds in the rough.