Are You Overreliant on This Classic Metric?

The trusty price-to-earnings (P/E) ratio may be the most quoted metric in the investment world. It's been used for decades by analysts and investors.

After all, it has a certain logic... It's the price of a share for each dollar of profit the company produces. So it should allow you to compare all companies on an equal footing.

After all, a dollar is a dollar, and all companies abide by the same accounting rules.

The problem is, people rely on price-to-earnings too much. And it could be causing them to miss out on big profits.

The Big Picture

Many investors use the P/E ratio to quickly size up a company. It's simple to say a company has a P/E of 20... and therefore it is cheaper than one with a P/E of 25. The assumption is that a cheaper company has more room to grow.

But P/E is not the only factor that affects stock prices. What it tells us must be interpreted with care.

We have to consider momentum... revenue growth... price-to-sales... and cash flow.

If you're looking at just P/E, then you aren't looking at the big picture.

What about the fact that some sectors and companies have high P/Es because their P/Es reflect their expected profit growth?

Take tech stocks, for example. The sector has been on fire. And yes, tech stocks will have higher P/E ratios than, say, banks or utility companies. But thinking that a low-P/E company has the most implied capacity for growth can lead you to a company with the least expected growth - the exact opposite of what you wanted.

Knowing this, say you decide to go for a company with a P/E ratio of 200. It may well be an overvalued company, the share price of which is signaling an imminent fall.

Again, this is why you can't rely on this metric alone.

Keep in mind that a stock's P/E ratio can be measured against its historical levels. Will the P/E return to those?

And will inflation impact P/E on top of all that?

So you can see that there are about a dozen things to consider beyond a simple P/E number.

More Important Than P/E

Here's another point about P/E... A legend like Warren Buffett hardly ever mentions it. You will be hard-pressed to find his thoughts on the metric anywhere.

Why?

Because he knows other measures such as cash flow and return on capital are more important.

So are growth and the ability to consistently sustain it.

After all, earnings are easy to manipulate - just ask any accountant. What is profit? Do you count as earnings a contract that's highly likely to be signed? Or once a contract is signed, do you count the income that will come in from it over the next 12 months today? What if the customer reneges? Cancels?

This is one more reason I, like Buffett, prefer cash measures. Cash is a lot harder to manipulate.

All the Numbers

And finally, consider this... The current S&P 500 10-year P/E ratio is 38.8. This is 96% higher than the index's all-time average P/E of 19.6. Yet, since 2010, the S&P's performance has been well above average and the index has delivered strong returns! Would you have stayed out from 2010 onward and missed one of the biggest bull rallies of our lifetimes?

I don't mind a higher P/E ratio because it implies growth. But I focus on all the subtleties and nuances mentioned above and examine other important factors as well. I use all the data available, not just one popular measure.

And in GVI Investor, I take all that data and turn it into wisdom. That's how I've beaten the S&P 500 for the past five years.

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Happy hunting,

Alpesh