Contrarian Views: The P/E Ratio as a Useful Indicator

By Nikhil Shamapant - July 11, 2012 | Tickers: AAPL, CCL, JPM, RAX | 0 Comments

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In his book, The Intelligent Investor, Benjamin Graham popularized the personification of the market as a guy, Mr. Market, who in his bipolar daily routine would offer both overly high and overly low prices for his friend, the investor. It was the investor's job to take advantage of Mr. Market's low prices and know to stay away when prices got too high. 

One common way for people to do this is by the use of the P/E ratio. Such a simple ratio holds huge amounts of power to investors everywhere. Some people won't invest in anything with a P/E ratio above 30. These investors may call themselves "value investors." Other people won't pay much attention to anything with a P/E ratio below 20. These growth investors take pride in the awe inspiring prices of their stocks and the reverence that their stocks' P/E ratio receives.

While I've seen many an article on the P/E ratio suggesting it's useless as a screener and can be completely misleading as an analytical tool(very true), I think that the P/E ratio is a tool that gets too much popularity for its complete misuse and not enough credit for its strengths. At its core, the P/E ratio is a ratio of Price to Earnings. It has many faults. First, it captures the state of a company in time. Almost like a balance sheet, it shows the ratio of price to earnings(trailing twelve month, forward expected earnings, or last annual) at a point in time, which doesn't necessarily give an investor obvious context for the ratio, ignoring things like growth of earnings or margins. Second, the P/E ratio totally ignores the balance sheet, so if a company is selling for below cash value it could still have an expensive P/E ratio and these investors who focus solely on PE would never know. On the other hand, if a company is super cheap by the P/E ratio and has out of control debt, the investor would remain just as ignorant.

The P/E ratio can, however, be a very useful tool for both value and growth investing. Normally, as a relative valuation ratio, the P/E ratio is supposed to suggest valuation of a company in comparison to other stocks, but the P/E ratio can even be taken on its own and interpreted. The best way, in my opinion, to interpret the P/E ratio, is as a method to speak to the market. The P/E ratio suggests the market's expectations. If beginning investors realized that a low P/E ratio doesn't mean "bargain stock" and actually means "deemed low quality and experiencing troubled times" far less value trap situations would occur. Similarly, a high P/E ratio doesn't indicate "expensive," it means "perceived as high quality, likely to outperform." 

Now, I'm not suggesting that investors should only buy high P/E ratios and avoid low P/E ratios, but I think that investors should realize that the market is pretty smart (the collective understanding of every investor) and might know something you don't. The key to investing is to look for misconceptions. Yes, the market is smart, but sometimes you can find low P/E stocks where things will turn out well, or high P/E stocks where the high expectations have set the bar higher than the company can possibly perform.

For example, take Carnival Corporation(NYSE: CCL). With a P/E ratio of 19, the future is expected to be bright for this cruise ship company. If you take a deeper look, it's clear why. Carnival has the highest market share in the cruise industry (by a huge margin) and is in an extremely asset intensive business. Competition isn't any trouble for Carnival and it's in control of its own future, so the market expects good things to come. I would hesitate to argue with the market on this one, Carnival seems pretty set to sail. 

Another example might be Rackspace Hosting(NYSE: RAX) with a P/E of 72. Rackspace has extremely high expectations, and it's in a high growth industry. Known for its customer service and high quality products, Rackspace has high expectations. However, the industry isn't without its competitors, so one could argue these expectations for Rackspace are far too high.

Don't Be Fooled

In the future, recognize that every investing thesis should be based on market expectations. Things aren't cheap or expensive on their own, and in the stock market, a cheap stock tends to just imply that in the future the stock will be expensive because of falling earnings, not rising stock prices. Here are 2 ideas that might merit further research based on this concept:

1. Apple Inc.(NASDAQ: AAPL) I know, I know, this is a stock everyone already owns. However, its current stock price supports a P/E of 14.7. To give you a comparison, Procter & Gamble trades at 19x earnings and has nowhere near the growth prospects of Apple's current business. So the market expects subpar growth at best from Apple, but the current price doesn't include the possibilities of a new iPad mini or an Apple TV or really any of the amazing innovation Apple is so well known for. There's difinitely a possible misconception on this stock, even if it is so well followed. 

2.  JPMorgan Chase & Co. (NYSE: JPM). Trading losses, Big Banks, Suits and WallStreet. It all reeks of the unfair, but I think with a dividend yield of 3.54% and a P/E of 7.54, JPMorgan is being unfairly treated by the stock market as well. Expectations for JPMorgan are low because of the huge mistake by management recently, but that shouldn't be representative of JPMorgan's long term business. 

Always make sure to do your own research before buying anything, but I think if you make sure to read the market's expectations and correct its mistakes instead of screening in and out of "cheap" or "expensive" stocks, your investment outlook should change dramatically for the better.

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