The Value of the P/E Ratio
By Cheryl Peress
Mutual Funds Editor
03/26/2000 10:45 AM
With the Dow flying to all-time highs, it
appears that investors are once again
flocking to traditional, stable, value
stocks. But, what constitutes value? A
main component is the price-to-earnings
or P/E ratio, once the bellwether of all
investment indicators.
"For businesses with stable and
predictable earnings -- electric utilities,
REITs, banks -- P/E gives a good idea of
the value of the business," says Martin
Whitman, veteran value investor and
manager of the Third Avenue Value fund
(TAVFX).
However, in this day of fledgling biotech
and Internet companies, the P/E ratio
can actually be very misleading.
"The old days of predictable valuations
are gone," says Bob Zucarro, portfolio
manager of the large cap growth Grand
Prix fund (GPFFX). "Stocks no longer sell
on P/E ratios. It's very difficult in the
current climate to use the P/E ratio as a
gauge."
A Basic Screen
The P/E ratio is calculated by dividing a
company's stock price by earnings. It
represents how much investors are
willing to pay for every dollar's worth of
earnings, and fluctuates with investor
perceptions of earnings growth.
Generally speaking, companies with high
P/E ratios tend to be emerging
companies in growth industries. Even
though current earnings may be scant,
investors anticipate rapid earnings
growth and are willing to pay up for the
stock. Conversely, large, established
companies with stable earnings growth
often have lower ratios.
P/E is a better comparison of the value
of a stock than the price. For example, a
$20 stock with a P/E of 50 is much more
expensive than a $200 stock with a P/E
of 10.
But, whether or not a certain stock is
overvalued or undervalued depends on
whom you're talking to. While Cisco
Systems (CSCO: Nasdaq) currently has a
P/E ratio of 200, there are some ardent
Cisco fans that believe the stock is a
bargain even at these lofty levels.
A depressed stock, one that trades at a
very low P/E ratio, may not be
undervalued in certain eyes, but rather,
just a poor company.
Many money managers use the P/E as a
basic screen for companies that they are
considering buying. Then they look at a
multitude of other factors that determine
stock price.
A Different Environment
The P/E ratio is a very useful indicator
for more seasoned companies. Whitman
invests primarily in highly cyclical, value
industries and looks for companies with
high quality assets, but which may have
a poor near term earnings outlook -- the
E in the P/E equation is very low. "The
P/E is high because they have not yet
converted resources to earnings."
In other words, Whitman has attached
much higher earnings growth prospects
than has the market. Although the
current P/E indicates a somewhat
expensive stock, Whitman sees it as
relatively cheap given his positive future
assessment.
But, how can you use the P/E ratio for a
company with no E? Some experts
believe that in the current environment,
P/Es are meaningless. "Some (P/Es) are
outrageously high, while others are
ridiculously low," says Zucarro. "Very few
stocks are advancing despite positive
earnings reports."
"The P/E ratio shouldn't be the be all
and end all," says Malcolm Fobes,
manager of Berkshire Focus (BFOCX), a
top-performing large cap growth fund.
"We have a checklist with 20 to 30
items," he says. "The P/E ratio is on the
list." But, it's certainly not the only
thing. Management, market share,
company health, competition, and the
economy are all weighed. "If there are
more green flags than red flags, we'll
buy the stock."
Fobes cites Exodus Communications
(EXDS: Nasdaq), a company that hosts,
manages and maintains company servers
and Web sites. Although not yet
profitable, Exodus has top-notch
management, dominant market share,
and a first to market advantage in a
growing market. "There are a lot of
intangibles," he says.
The PEG Ratio
There are other incidences where the P/E
ratio can be misleading. "For tech
companies who make acquisitions on a
regular basis and take write-offs against
earnings, the E in P/E is smaller, which
in turn makes the P/E ratio higher than it
really is," says Fobes.
With a P/E of 200, Cisco appears to be
highly overpriced at first glance. But,
because earnings have been reduced as
a result of recent acquisitions, the P/E
number is really misleading.
Instead, Fobes prefers to look at the
PEG ratio, another gauge of value,
measured by dividing the P/E ratio by
expected future growth. It's a useful tool
when comparing companies within the
same industry.
Fobes compares Microsoft (MSFT:
Nasdaq) to Intel (INTC: Nasdaq). While
the two are not exactly in the same
industry, they are both bellwethers in
the tech arena.
Microsoft has a P/E of 64 and Fobes
expects a growth rate over the next five
years of roughly 35%. Dividing 64 by 35
gives a PEG ratio of 1.83. Intel has a
similar P/E ratio at 60, but the
consensus five-year earnings growth rate
is 20%. That gives a PEG of 2.97.
Looking at the P/E ratio, the two
companies appear to be of similar value.
But according to the PEG ratio,
"Microsoft looks pretty inexpensive,"
says Fobes.
worldlyinvestor.com
Lynn |
