STOCKS ARE CHEAP, BUT THIS METRIC DOESN’T WORK?
STOCKS ARE CHEAP, BUT THIS METRIC DOESN’T WORK?
Courtesy of The Pragmatic Capitalist
I’ll be frank – I have a special place in my heart for the PE ratio and it is the same place where all the things I hate are stored. This simple to understand metric has, in my opinion, resulted in more misguided Wall Street thinking than just about any metric in existence. A quick glance at the breakdown of the PE ratio shows serious flaws at work here. It is basically a moving price target (which is never correct unless you still believe in EMH) divided by the earnings estimates that are created by analysts who have literally no idea where future earnings will be. In other words, you might as well pick random numbers out of a hat and divide them and then go buy or sell
What disgusts me even more about this metric is its incessant use in selling buy and hold strategies. You can’t read a book on value investing or buy and hold without running into the PE ratio. “The market is cheap – stocks for the long-run!” You’ve probably seen this slogan on every mutual fund pamphlet you’ve ever read. Your stock broker no doubt thinks the market is “cheap” right now. The PE ratio has become the sales pitch of an entire generation of sales people who are just herding small investors into fee based products. “Did you know Warren Buffet is a value investor?” “Just buy cheap stocks and hang on. Your status on the list of the world’s richest is in the making!” Or so goes the old sales pitch.
So, I wasn’t surprised to open Yahoo Finance this morning to see the following headline arguing that stocks are cheap according to the PE ratio. But just two articles down is an article from the WSJ arguing that the PE ratio doesn’t work in this environment. You can’t make this stuff up. According to the article:
“Not only is the P/E ratio dropping, it also is in danger of losing some of its…
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