Poo-Poo The Price Earnings Ratio

Value investors have traditional viewed the P/E ratio as an integral part of their stocks analysis. Now, according to a recent WSJ article, investors are shying away from using P/E ratios only because of the future uncertainty of company profits.

According to WSJ write Ben Levisohn, three months ago analysts expected companies in the S&P 500 index to boost profits by 18% in 2011. Today they predict an increase of 15%. Mutual fund, hedge fund and other money managers put the increase closer to 9%, according to a recent Citigroup survey while others put it around 7%.

Howard Silverblatt, an index analyst at S&P said, ‘ The  sustainability of earnings is in doubt.’ This is an attitude that seems to be universal in the investment management world. Fund managers and others are hesitant to put money to work if the future is murky.

P/E ratios dropped during the inflationary 1970s and fell during the deflationary 1930s. The two things those eras had in common was unpredictable economic performance.

So what is a P/E ratio? It is simply a measure of the price paid for a stock (or the current trading price) relative to the annual net income or profit. If the P/E is high that means the price of the stock is expensive in relationship to the profit it earns. A reasonable P/E for the S&P 500 index is 14.  Currently the S&P index P/E is 13.

How does that match up with history? The historical S&P Price/Earnings over the past 15 years has ranged between 11-28 times. The current P/E makes it a compelling number signaling the market is not expensive. The P/E is actually at 1970s levels while interest rates are at 1930s levels. Even inflation is negligible.

This would make a persuasive case for stocks if it were not for jobs, government uncertainty and housing. Until one or all are clarified and investors see easing the markets will continue to trade in their narrow range even with the current attractive price to earnings ratios.

If you have questions call Paul @ 877 783 7080 or write him at pstanley@westminsterfinancial.com. Share this blog with someone who cares about their money.