Are profit multiples dead?

Wall Street's bloggers were agog last week. The iconic Wall Street Journal ran a column announcing, no less, that not only are price/earnings ratios declining, their importance is waning too.

The P/E ratio is the ratio between the company's market cap (price ) and its profit (earnings ). Of all the economic parameters by which investors judge investments, it is king. Every market novice knows enough to parrot, "A ratio below 10 is cheap and a ratio greater than 20 is too much."

The ratio appears on the front pages of all stock analyses, by virtue of Benjamin Graham and David Dodd, the fathers of basic financial research.

When a company's market cap (or share price ) is divided by its net profit (or earnings per share ), you get a number that reflects what investors are willing to pay for the company's profits. Some see it as a reflection of time - how much time it will take to recoup one's investment.

The faster a company's profits grow, the higher the ratio investors will pay. When a company surprises on the upside with its profits, its ratio drops (because profit is the denominator ) and the share price must rise to restore the ratio to its place.

But in recent weeks, says the WSJ, U.S. companies are reporting sharply higher profits, and their share prices are plunging.

The result is that the average P/E ratio of American stocks has fallen by no less than 36%, to 14.9, compared with 23.1 in September 2009.

Why? The WSJ blames the pullback on dire economic forecasts.

If past figures do not reflect the future, and forecasts for corporate profits are badly skewed upward, then P/E ratios lose their meaning. A share's value, and therefore its P/E ratio, depends on future profits, and if future profits are shrouded in uncertainty, its P/E ratio becomes unreliable. In turn, if you aren't sure about the quality of a financial asset, you won't pay much for it.

Further buttressing its argument, the WSJ says that the range of analyst forecasts is wider than ever. P/E ratios are more reliable if the range is tighter. When you look at P/E ratios, you have to keep in mind that they represent an average of opinions (about future earnings ).

In short, says the WSJ, in an uncertain world in which eyes are fixed on global macroeconomic indexes, in which the public trades through exchange-traded notes and computer programs that seek out distortions in the market, the entire school of financial analysis is bankrupt. Bye-bye, P/E ratio.

But is that so?

The Journal's wrong, which is a pity

We think the WSJ is wrong, and too bad, because the P/E ratio misleads. The world of investing in stocks is a highly complicated place, comprised of myriad bits of information that change day by day. People will always seek simple rules of thumb to guide them through the thicket.

Amateurs and pros alike want a single figure that makes them feel they know something about shares. The P/E ratio is that very thing. They think they can use it to compare investments.

Who would forgo a compass that simple, intuitive and convenient, when there's nothing in its stead? We think it will be around for years to come.

That's a shame, because the P/E ratio causes more damage than good.

It's a rule of thumb that all too often doesn't apply. It makes people make wrong decisions because it's a formula that depends on the quality of input. Garbage in, garbage out.

If the ratio is calculated based on past profit, you get a result that says nothing about the future. It's like driving a car by looking in the rearview mirror. The situation isn't much better when you use future earnings because analysts have only the vaguest idea what a company might do and no idea at all about its long-term prospects.

If there's a danger in the investment world, it's when amateur analysts think they know what they're doing. P/E ratios are wonderful for brokers selling stuff. But there are no shortcuts in the real world, and you are kindly advised not to make any investment decisions based on the P/E ratio alone.