Analysis: Are P/E Ratios Useless?

The popular multiple, once favored by analysts and investors to gauge a stock’s relative value, is in jeopardy of losing its purpose in today’s faster paced, forward-looking trading environment.

P/E ratios have skyrocketed due to soaring stock prices and lower corporate earnings

August 28, 2020. It’s no secret: P/E ratios are insanely high.

The P/E ratio, or price-to-earnings ratio, used to be considered the analytic benchmark for sussing out overpriced and inexpensive stocks. Yet P/E ratios have risen sharply in recent years, and since the pandemic, they’ve jumped even higher: The S&P500 index’s overall P/E is now 51x, compared with an historical average of 17x. The disparity is even greater in growth sectors like biotech and software, where P/E ratios are often north of 60x, according to recent data from online broker E*Trade.

A combination of booming share prices and stagnant corporate earnings are skewing P/E ratios across all industries, leaving many investors wondering if the time-tested metric plays any role in modern market trading.

Historically, the P/E ratio was handy in two different ways: By dividing a stock’s current market price by its earnings per share (EPS) from the previous twelve months, the resulting figure represented the number of years it would take a company to repay its current shareholders at its current level of earnings.

The more popular use of the P/E ratio was to assess a stock’s relative value compared to other shares in the same sector. A stock with a lower P/E could signal a good buying opportunity; a higher P/E could signal the share is overpriced. More established industries like utilities have traditionally traded at lower average P/E ratios (around 6x) than more innovative areas with less established cash flows and more potential future growth, like technology (around 20x+).

In a recent analyst note to investors, Dan Suzuki, deputy chief investment officer at Richard Bernstein Advisors, observed that all sectors of equities have been experiencing ‘multiple expansion’ of their P/E ratios above their traditional values, but the increases are not all for the same reasons. The market’s biggest technology companies - the so-called ‘FANMAG’ stocks - has a ‘P/E [that] has risen because their ‘P’ (prices) has gone up faster than their ‘E’ (earnings), while the P/E for the rest of the S&P 500 has expanded because ‘E’ has gone down much more than ‘P’,” he wrote. All of this makes sense, but what Suzuki doesn’t indicate is whether either explanation is a signal to investors to sell, or if higher P/E values are here to stay.

Of course, most investors today aren’t interested in companies that aren’t planning on growing their ‘E’ (earnings) side of the ratio in the future, which is why many of the hottest sectors right now include companies with little or no historical earnings track records whose P/E values are based entirely on their future growth potential. Biotech and electrical vehicle stocks are on fire for just this reason; if you count yourself among this investor base you’ll already know that comparing P/E ratios is a pretty useless exercise.

The counter-intuitiveness of the P/E ratio is why many analysts favor the PEG ratio, or forward P/E ratio, based on a company’s estimated future earnings, as a more useful variation on the backwards-looking P/E ratio. But even PEG struggles to quantify the current market’s buoyancy, in part because estimates of future earnings alone do not account for the massive surge in stock prices.

P/E and PEG ratios - and EBITDA/EV and their brethren - are in danger of becoming relics of an older generation of stock investing. Today’s markets are quicker, freer and more opportunistic. Fee-free trading apps like Robinhood, fractional trading, options and swaps contracts, and social media messaging are just some of the new forces driving new investor behavior and influencing pricing. That’s not the whole story behind the market madness, but for old school portfolio theorists it’s frustrating to watch popular stocks outstripping shares with more intrinsic value. Add to that rockbottom interest rates that are driving investors away from fixed income investments and into stocks, plus trillions of new dollars thanks to the Fed’s fiscal stimulus, and it’s pretty easy to see why ‘P’s (prices) have no where to go but up, regardless of what’s going on with company earnings.

Take Tesla: At $2,200 (pre-split) per share and a P/E of 1,153x, Tesla’s stock price may well have been plucked from thin air but that hasn’t stopped younger investors and momentum traders from boosting Its shares more than 400% this year. That’s real money whether Elon Musk & Co have anything to show for it or not.

So if old-school valuation metrics no longer apply, where should investors look for guidance? There’s no magic answer, and if there was I wouldn’t be writing a free blog about it.

The best hints lie in the same new forces that are influencing the market itself and causing the ‘P’s to fly past the ‘E’s. That doesn’t mean throwing away the investing textbook and following the herd, but it’s important to modify our techniques to take into account the shifting paradigm as we make investing decisions. It’s heady days in the current market for lots of reasons, but the fundamentals suggest it’s only going to get headier. Take a deep breath, and dive in carefully - regardless of everything we ever learned about P/E.