Reliance on price-earnings ratios called into question as best stock-picking gauge

Posted: Thursday, August 15, 2002

NEW YORK (AP) -- An investor just doesn't know what to believe anymore.

All the CEO scandals, controversy over stock options and financial restatements made the accuracy of corporate earnings suspect.

And if you can't trust the earnings, you can't rely on the price-earnings ratio that has long been a key formula for making stock picks.

''Earnings are just too easy to manipulate,'' said Ken Stern, who runs a portfolio management firm in San Diego. ''No one is really sure what earnings mean anymore, and that is causing some reliance on P/Es to fade.''

Investors have long used P/E ratios to help them assess a stock's value. The P/E shows the relationship between the price of a company's shares and its earnings over the last 12 months. If a company earns $1 a share and trades for $10, that means the P/E ratio is 10.

Historically, lower P/Es are generally found in value stocks, which are older and more stable companies. Higher P/Es are usually linked to growth stocks in riskier industries.

On its own, the ratio's value is virtually worthless. High and low is relative to other companies in the same industry, and a stock can be considered undervalued or overvalued depending on its comparison with its peers and historical moves.

For instance, Wal-Mart Stores Inc.'s P/E trends around 23, which is in line with the broader retail industry and the discount-stores sector. Intel Corp.'s P/E, however, is about 32, less than half of others in the technology industry and 6 points below the average of chip manufacturers.

A company's P/E is also often compared with the average P/E of the stocks in the broad Standard & Poor's 500 index, which now stands at about 18.

''You can't look at the P/E in a vacuum,'' said Kevin Pianko, a partner at the New York accounting and advisory services firm Richard A. Eisner & Associates. ''You must compare it to past trends, the industry it operates and where it is in regard to competitors.''

The reliance on P/Es initially began to crumble in the late 1990s, when the Internet boom thrust many stocks into the market that weren't making any money. Without earnings, it's impossible to formulate P/Es, and as a result many investors used sales as the basis of their analysis.

Yet it wasn't long before P/Es came back as the preferred valuation method. The dot-com collapse drove investors to once again seek out companies with earnings potential.

But the use of P/Es is now in question again. Blame it this time on the fact that investors are nervous about corporate earnings.

Just look at Merrill Lynch's August survey of 292 professional fund managers worldwide, which showed 31 percent believed that U.S. stocks had the worst quality of earnings compared with stocks in other global markets. That's up dramatically from 7 percent a year ago.

Over the same time period, 19 percent of fund managers said they think U.S. corporate earnings were of the highest quality globally, down from 62 percent in August 2001.

Fueling the sliding sentiment is the recent wave of corporate scandals, which has raised fears about corrupt CEOs who cook the books for personal gain.

Also spooking investors is the rash of earnings restatements over the last year. Many companies are revising their financial statements to reconcile for past mistakes, which include overstating revenues and hiding bad debts.

Then there is the issue of stock options. Since most companies don't expense these volatile and potentially costly perks, investors believe they aren't getting the full picture of how the options cut into profits.

''Earnings have become questionable, mostly because some companies aren't using reasonable accounting standards,'' said Gary Gray, visiting finance professor at Penn State University and author of ''Streetsmart Guide to Valuing a Stock.''

With earnings under attack, investors are seeking out more accurate metrics for stock valuation.

There's already a push by some to develop new measures to calculate corporate earnings.

Influential ratings agency S&P is now using ''core earnings'' in its analysis. It only focuses on a company's ongoing operations, adding in expenses from stock options and subtracting items not directly related to the business, such as litigation settlements and merger costs. S&P plans to use ''core earnings'' when calculating the P/E of the 500 stock index later this year.

Merrill Lynch is altering how it analyzes earnings, too. Among the changes: It will look at how close a company's earnings are to being realized in cash and how much a company's earnings are dependent on reporting low taxes.

And many investors are making a more diligent effort to compare P/Es with other valuation tools, including price-to-cash flow and price-to-sales ratios.

''If you are looking for a stock to buy, you want to seek out some confirmation that it is cheap based on among all the tools you use. That's why you don't want to just stick with the P/E ratio,'' said Paul Greenwood, senior research analyst at Frank Russell Co. in Tacoma, Wash. ''In today's market, you need to compare different measures, and then ask yourself whether this is really a good buy.''

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