Five reasons why investors should not rely on P/E ratios

Question: My broker told me that there were few stocks that I can buy nowadays because most stocks were already trading at high P/Es. Should I buy remaining stocks with low P/Es?—Shay by e-mail

Many investors are probably hesitant to buy stocks at this point in the market because many feel that most stocks are already expensive or the market may have become overvalued.

One of the most common measures of valuation that is used by the market is the Price-to-Earnings (P/E) ratio. This ratio tells investors if a stock can be considered cheap when its P/E ratio is low relative to other stocks or expensive if its ratio is higher compared to the market average.

With the current market P/E of 21x, which makes the market historically expensive, there may indeed be valid concerns among investors that further upside may be limited.

But what if the market continues to go up in the next few weeks and let’s say the market P/E average shoots up to 30x? How will the market justify a high P/E valuation? Imagine if the market average P/E is 40x, will you still consider a stock attractive because it is trading at 30x P/E? How reliable is P/E ratio as benchmark of a stock value? What exactly is the P/E ratio?

The P/E ratio is simply the closing price of a stock divided by the earnings per share. If the earnings per share of Double Dragon (DD) is P0.26 per share for the last 12 months and its current share price is P56, this means that investors are willing to pay 222 times its current earnings, which is way above market average of 21x.

1. P/E ratios do not account for growth

By relative P/E valuation standards, DD is ridiculously overvalued but investors are willing to hold. The stock has been holding up pretty well so far. Why? One reason could be that investors perceive the company as trustworthy. Investors believe the company can deliver its promise to generate big earnings in the future, which makes current price reasonably undervalued. In other words, investors are paying not for the stock’s immediate earnings but its future, which makes current P/E ratio irrelevant. This is one of the major flaws of using P/E ratio as guide in selecting stocks because it does not take into account long-term valuation.

In the same token, a stock with low P/E does not necessarily make it cheap. In fact, it can be signal that something may be wrong with the company or the market may simply not like the management.

Some stocks with comparatively lower P/E ratios maybe fairly priced already and are not deemed undervalued given their growth prospects.

2. P/E ratios do not reflect quality of earnings

Earnings are subject to manipulation through creative accounting. For example, a listed company can increase earnings by way of increasing their sales through accounts receivable. The effect on P/E ratio will be lower because of higher earnings but no real value is actually created because the company did not improve its cash flows.

Another example is when a company buys back its shares from the market. A share buyback decreases the shares outstanding of the company, which artificially increases the earnings per share. Higher earnings per share makes a stock look cheap through lower P/E ratio but no real increase in income was achieved.

3. P/E ratios do not reflect debts of the company

GMA7 and ABS have similar P/E ratios of 11x but they differ on their capital structure. ABS has more aggressive gearing with 1.5x debt-to-equity ratio compared to GMA7, which has conservative 0.6x debt-to-equity. Different leveraging strategies, which reflect the amount of risks taken to finance future growth of the two companies, are not reflected in their P/E ratios.

4. P/E ratios do not focus on long-term earnings

P/E ratios either use earnings from the most recent four quarters or projected earnings in the next 12 months. The focus is short-term in nature and does not capture the long-term outlook. Take the case of PLDT. This stock used to trade at average P/E ratio of 15x in the past years but earnings started to fall this year  because of the company’s plan to shift its business model from traditional to digital in three years. Lower earnings prospect put PLDT’s current P/E ratio at 26x.

Based on P/E benchmarks, PLDT is expensive despite losing 24 percent in its share price this year and it is possible that this stock may fall further. But if you are buying on long-term view with trust and confidence in their management, this stock could be bargain.

5. P/E ratios do not reflect investment returns and margins

SM Prime (SMPH) and Robinsons (RLC) have similar business profile but they differ greatly in valuation. SMPH is trading at P/E ratio of 38x while RLC at 21x. Following the rules of P/E ratios, SMPH will look overvalued while RLC relatively undervalued.

But a closer look at average returns on equity for the last five years of both companies will show that SMPH has higher returns of 14 percent compared to RLC’s 10 percent. Moreover, SMPH’s average net profit margin is also higher at 32 percent compared to RLC’s 29 percent. Current valuations show that investors are willing to pay premium for SMPH shares because the company is far more superior to RLC, making the P/E ratios again irrelevant in this analysis.

P/E ratios can serve as quick reference for investment comparison but are not absolute measure of value. Investing in stocks using P/E ratios as your only guide can be dangerous. It always pays to research and understand first the business of the stock before you decide to invest.

Henry Ong is a Registered Financial Planner of RFP Philippines. Stock data and tools provided by Technistock. To learn more about stock analysis and value investing, attend the 9th Accredited Financial Analyst (AFA) program this Sept 10-Oct 15. To register, e-mail [email protected] or text <name><e-mail> <AFA> at 0917-9689774.