Why Price/Earnings Ratios Don’t Tell Us Very Much
Price to earnings is relied upon by a lot of people in deciding a stock’s outlook. The idea is to hope that we’ll get a reversion to the mean. This isn’t how stocks work though.
We have a natural tendency to want to oversimplify things, and this certainly extends to how we view the movement in the price of stocks. If only stocks were as simple as bonds are, where you can at least get away with just seeking yields and monitoring the influences upon them.
We know that, while the price of bonds is driven by supply and demand as stocks are, it does so by pricing yields. There can be more or less demand for this, but this comes down to what yields investors are prepared to accept, and the way that changing fundamentals such as interest rates and inflation shape these yields.
We can enjoy a comparable level of simplicity with preferred stock, which really doesn’t change in value much but instead pays out by way of dividends. If earnings go up, you make more, and when they go down, you make less, and it’s all a pretty simple matter actually. Predicting future earnings isn’t necessarily all that easy of a task, but it’s one that we can focus on, and even those who know little about how to do this can’t go too far wrong buying a piece of whatever the company makes going forward providing the company is indeed profitable.
When we take this view and apply it to common stock, this is where we leave the road and venture off into a much more complicated ecosystem that really doesn’t have very much in common with preferred stock at all. Pretending that these two types of stock are substantially similar, allowing us to transpose the approach with preferred stock to common stock, will lead to a lot of confusion and tend to yield decisions that can be well out of touch with the realities that shape common stock prices.
Price to earnings ratios are very much relied on by a lot of people though, and if we’re going to use this, we need to understand how little of a force this actually is with the movement of stock prices.
The real fork in the road between the two is where they separate as far as the significance of earnings goes. Preferred stock is all about earnings, period. Common stock is mostly about capital appreciation. Preferred stock has the price of the stock set at par, and it is earnings that determine the value of the stock. With common stock, where the price now is allowed to fluctuate, it’s the stock price that matters the most here.
Stock Prices Are Moved by Many Other Things
We could look at the moving parts of the stock and see only one with preferred stock, dividends, but with common stock, there are two wheels, price and dividends, and the price wheel is by far the bigger of the two. The smaller dividend wheel does move the price wheel by a certain amount, but the bigger price wheel is driven by so many other things, such that the dividend wheel really isn’t that significant.
If we make the mistake of just looking at dividends, we’re going to miss most of what is actually going on with the stock’s price and end up pretty lost at times, a lot of the time actually. What value investors do is assume that yields are the whole ball game here, which means that any deviation from the mean will see market forces seek to normalize it.
If your price to earnings ratio is above average, the stock is therefore overpriced and may be expected to decline, where if it is lower than average it should climb to where this disadvantage is corrected.
This might actually be the case if common stocks were just about income flow like bonds and preferred shares are. We categorize these assets in the income class, but common stock is among an entirely different class, the growth class, and the two are completely different animals.
Where the value of income assets is contained in changing dividend yields, dividends really only play a small role in the value of common stock generally, and this actually is a very obvious point. When we buy a stock, we generally focus on the potential for capital appreciation, not dividends. Some do buy common stock for dividend purposes but they very often don’t account for price fluctuation anywhere near as much as they should, and will often even ignore it, but this is never a good idea.
Stocks vary quite a bit in their price to earnings ratio, and this is not just because they are undervalued or overvalued. It is because there is so much more to the story of a stock’s price than earnings, and the list is both a long one and exerts significant influence on prices.
Where Earnings May Be Headed Matters, But Only Because People Trade on This
We do know that earnings do influence prices somewhat, which is easy to see when we look at how earnings reports affect the price once they are released. We can easily measure the effect of this, and it’s actually the difference between the price on the day before and the day after these reports are shared with us.
We do see some measurable changes here, but overall, these changes only represent a small portion of a stock’s overall ride up and down the charts. The rest is decided by other things, and if we just focus on this one thing, current earnings, and assume that this is all there is, when there is so much more, that’s going to get us in trouble as we have placed ourselves well out of touch with reality.
The earnings reports in among themselves aren’t so much based upon what has happened as they are with what may happen, earnings forecasts in other words, and this is the real meat of these reports. The earnings portion of the price to earnings ratio is a static metric though and doesn’t account for anything in the future, because the baseline earnings number is whatever it is per share now.
The price does change though over time, often by quite a bit, which can increase or decrease the P/E ratio, but we cannot just assume that it is earnings that somehow drive this price. Ironically, when a stock price rises, this puts down P/E and if we are relying on this ratio, this would be bearish, with pullbacks being bullish because the ratio will go up when a stock’s price declines.
Therefore, a value investor may not be that concerned when the price of their stock declines, because it is gaining in value in their eyes. They may think that they should buy more and more as the price keeps going down because the stock becomes a better and better deal. Conversely, when a stock goes up, they should sell more and more because its value keeps declining with the upward movement, as ridiculous as this may sound.
Dividends do cushion the blow of declining stock prices somewhat, but of the two, price is the bigger beast by a big margin, with most stocks anyway, those whose volatility is comparable to the market. Utility stocks are the exception, because they don’t move anywhere near as much in price and their dividends are higher generally, but even in this case this does not mean that we can just focus on the dividends and treat these like preferred stocks where price isn’t part of the equation.
It’s fine to take earnings into account, as it’s not that they don’t matter at all, but what really matters isn’t where they are now but instead where they are going. Even this isn’t that influential, as while it does provide adjustments to price from time to time, once a quarter plus what other news the company releases or however the view may change among analysts along the way, the totality of all this does pale in comparison with the sum total of all the other factors that drive stock prices, especially the impact of market forces overall, which has nothing to do with a company’s earnings or even the company.
Since price growth is what we generally seek here, and price growth is also what investing in common stock is all about, this is what needs to garner most, if not all, of our attention. We are actually much better off just ignoring price to earnings than we would be exclusively focusing on them. Their only real influence is how changes in earnings may affect the supply and demand for the stock going forward, as the current situation is already fully priced in, whatever P/E ratio the market has decided is appropriate at this time.
Current P/E is actually a pretty meaningless statistic, and those who insist on using it as a primary decision driver will find themselves pretty out of touch, even though this includes people that claim considerable expertise. The biggest part of expertise is an expert level of understanding though, understanding what actually moves stock prices in this case. Without this, we’ll just be trading on illusions, as popular as this may be.
Chief Editor, MarketReview.com
Ken has a way of making even the most complex of ideas in finance simple enough to understand by all and looks to take every topic to a higher level.
Contact Ken: ken@marketreview.com
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