The P/E = value myth

Of late there has been an increase in the the popular pastime of market commentators pointing to the P/E as an indicator that the market is not overvalued. The P/E ratio is also used as a popular tool for individual stock selection. Those who employ this kind of measure would say that a company trading on a low P/E is cheap and a high one expensive. They may even be more sophisticated and say that a company trading on a high P/E may not necessarily be expensive because of high rates of growth in profits.

However the P/E ratio tells you nothing about how that profit growth is achieved. It doesn't tell you whether growth is achieved organically or with the aid of large injections of equity or debt or both. The P/E ratio doesn't help investors identify businesses with superior economics. It doesn't tell you the proportion of dividends paid out to the owners (shareholders) of the business and therefore how much of its profits can be reinvested at high incremental rates of return. If you were to point these shortcomings out to those who embrace the P/E as a measure of value you would probably be greeted with a blank stare or a hostile rebuke. Below is a short article from the Stockval website that neatly summarises the shortcomings of the P/E as a measure of value.

The Price/Earnings (P/E) ratio is simply the market price of a company's shares divided by the company's earnings per share. It is widely (and wrongly) regarded as a measure of value - supposedly a way to quickly determine if a company's shares are cheap.

Market commentators, amateur investors and even some professionals use it because it is easy to calculate. But for investment success the path of least resistance is not reliable.

Two companies, each with $10 of equity, producing a return on equity of 5%, and each trading on a P/E ratio of 10, would produce entirely different returns to the investor if there was any variation in the dividend payout ratios. For this reason the P/E ratio of 10 has told the investor nothing about which company is better value.

Put simply, Price is what you pay, but Value is what you get. Because the P/E ratio uses price it cannot estimate value.