Understanding the Price-Earnings Ratio

I don’t use the P-E ratio much in evaluating the stock market. There are a lot of reasons for that. Earnings are, well, flexible. They’re subject to revisions and manipulation. I definitely don’t recommend using forward, or forecast, earnings, because they can be way off the mark. But the big reason is that earnings are cyclical. Often when earnings and profit margins are at their best is when the economy is nearing a peak and earnings are about to fall, or at least stop growing. Shawn Tully of Fortune puts earnings and P-E ratios in good perspective in this piece. His conclusion is that bullish investors who say stocks are trading at the lowest levels in 20 or 25 years are misreading earnings.

But just because stocks appear cheap based on today’s P/E ratio doesn’t mean they really are inexpensive. The current P/E is a highly unreliable measure of when to buy. The problem is that earnings are extremely erratic, regularly careening from highly inflated to extremely depressed, always reverting from those extremes to long-term averages, as if pulled by a gravitational economic force. When profits are in a bubble, the current P/E is artificially low, wrongly implying equities are a bargain. When they’re depressed, the P/E signals to shun them just when investors should buy. For example, the huge earnings posted in 2006 made equities look attractive, while the paltry profits in 1991 made them look pricey. Investors who bought in 1991 fared far better over the next several years than folks seduced by the ephemeral bargains of 2006.