P-Es aren't perfect for picking stocks
A: Wouldn't it be great if all you had to do was buy a stock with a low P-E, hang on, wait for it to "get discovered" by other investors and then sell it for a quick profit? Unfortunately, investing isn't that simple.
P-E ratios are handy tools for investors. They tell you how much investors are willing to pay for each dollar of a company's earnings. They are calculated by dividing the company's stock price by its earnings per share.
The higher the ratio, the more badly investors want to own the stock. When a P-E gets too high relative to the rest of the stock market, its industry or even to its historical P-E range, that should make you stop and ask why that may be the case.
And there is some evidence that stocks with low P-E ratios have produced above-average returns, even adjusted for risk, according to the book A Random Walk Down Wall Street by Burton G. Malkiel. But Malkiel points out that this approach doesn't work all the time and a company's accounting can skew its P-E ratio.
P-E ratios by themselves aren't always good ways to make money in stocks. Sometimes stocks with low P-Es are cheap for a reason. They may be trying to sell products nobody wants, or have other problems. If that's the case, there's no guarantee the company will try to fix its problems. And even if it does, that doesn't mean the efforts will be rewarded by investors.
Consider Ford. In 1995, the automaker had the lowest P-E ratio of all the members of the Standard & Poor's 500, according to S&P's Capital IQ. But investors who bought Ford stock on Dec. 29, 1995 because of its low P-E and held it would be disappointed, because - despite a runup in the interim - the stock was lower on Dec. 30, 2005. Certainly, you can find plenty of examples of stocks that did have low P-Es and ended up doing rather well, but it's not a guarantee.
So, what's another problem in choosing stocks that have low P-Es? You might miss out on some great stocks with high P-Es. A good example is Google. The stock ended 2004 at $192.79 a share and reported earnings for the year of $1.46 a share. That gave the stock a staggering 132 P-E. Using your rule, you would have avoided Google. But guess what? The stock gained another 115% in 2005, making it one of the best performers on the Nasdaq.
The final problem with P-Es is how to decide what's a "low" P-E. You might say 15 is low. Someone else might think that's expensive. It really depends on what industry you're looking at. A 15 P-E is high for regional banks, but low for technology companies.
Again, this is not to say P-Es are worthless. They are definitely important for investors to monitor and can be great benchmarks to show how popular a stock is. And sometimes, buying stocks with low P-E ratios relative to the stock market can pay off handsomely. When I analyze a stock, the P-E is one of the things I consider. But they aren't a perfect tool, so you shouldn't treat them that way.
